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LIMESTONE BANCORP, INC. - Quarter Report: 2012 September (Form 10-Q)

a50468111.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 FORM 10-Q  
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended September 30, 2012
 
Or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
 
Commission file number: 001-33033

PORTER BANCORP, INC.
(Exact name of registrant as specified in its charter)
 
     
Kentucky
 
61-1142247
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
   
2500 Eastpoint Parkway, Louisville, Kentucky
 
40223
(Address of principal executive offices)
 
(Zip Code)
 
(502) 499-4800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x     No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ¨    
Accelerated filer  ¨    
Non-accelerated filer  ¨
Smaller reporting company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s class of common stock, as of the latest practicable date.

12,007,127 shares of Common Stock, no par value, were outstanding at October 27, 2012.

 
 
 

 
 

 
INDEX
 

   
Page
 
1
 
 
35
53
53
     
 
55
55
55
55
55
55
55
 
 
 

 
 

 
 
PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

The following consolidated financial statements of Porter Bancorp Inc. and subsidiary, PBI Bank, Inc. are submitted:

Unaudited Consolidated Balance Sheets for September 30, 2012 and December 31, 2011
Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2012 and 2011
Unaudited Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2012 and 2011
Unaudited Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2012
Unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011
Notes to Unaudited Consolidated Financial Statements
 
 
1

 
 
PORTER BANCORP, INC.
Unaudited Consolidated Balance Sheets
(dollars in thousands except share data)
 
   
September 30,
2012
   
December 31,
2011
 
Assets
               
Cash and due from financial institutions
  $ 78,688     $ 104,680  
Federal funds sold
    3,094       1,282  
Cash and cash equivalents
    81,782       105,962  
Securities available for sale
    198,148       158,833  
Mortgage loans held for sale
    210       694  
Loans, net of allowance of $54,019 and $52,579, respectively
    897,792       1,083,444  
Premises and equipment
    20,955       21,541  
Other real estate owned
    48,837       41,449  
Federal Home Loan Bank stock
    10,072       10,072  
Bank owned life insurance
    8,328       8,106  
Accrued interest receivable and other assets
    19,917       25,323  
Total assets
  $ 1,286,041     $ 1,455,424  
                 
Liabilities and Stockholders’ Equity
               
Deposits
               
Non-interest bearing
  $ 111,403     $ 111,118  
Interest bearing
    1,066,124       1,212,645  
Total deposits
    1,177,527       1,323,763  
Repurchase agreements
    2,403       1,738  
Federal Home Loan Bank advances
    5,960       7,116  
Accrued interest payable and other liabilities
    12,967       7,628  
Subordinated capital note
    7,200       7,650  
Junior subordinated debentures
    25,000       25,000  
Total liabilities
    1,231,057       1,372,895  
                 
Stockholders’ equity
               
Preferred stock, no par, 1,000,000 shares authorized,
               
Series A – 35,000 issued and outstanding;
               
Liquidation preference of $35 million at September 30, 2012
    34,795       34,661  
Series C – 317,042 issued and outstanding;
               
Liquidation preference of $3.6 million at September 30, 2012
    3,283       3,283  
Common stock, no par, 86,000,000 shares authorized, 12,007,127
and 11,824,472 shares issued and outstanding, respectively
    112,236       112,236  
Additional paid-in capital
    20,179       19,841  
Retained deficit
    (119,181 )     (91,656 )
Accumulated other comprehensive income
    3,672       4,164  
Total stockholders' equity
    54,984       82,529  
Total liabilities and stockholders’ equity
  $ 1,286,041     $ 1,455,424  
 
 
See accompanying notes to unaudited consolidated financial statements.
 
 
2

 
 
PORTER BANCORP, INC.
Unaudited Consolidated Statements of Operations
(dollars in thousands, except per share data)
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Interest income
Loans, including fees
  $ 12,797     $ 16,652     $ 40,998     $ 52,351  
Taxable securities
    837       987       2,475       3,168  
Tax exempt securities
    220       298       666       826  
Fed funds sold and other
    133       166       415       572  
      13,987       18,103       44,554       56,917  
Interest expense
                               
Deposits
    3,568       4,966       11,294       15,598  
Federal Home Loan Bank advances
    50       138       161       419  
Subordinated capital note
    66       69       204       213  
Junior subordinated debentures
    169       156       508       468  
Federal funds purchased and other
    2       119       6       355  
      3,855       5,448       12,173       17,053  
Net interest income
    10,132       12,655       32,381       39,864  
Provision for loan losses
    25,500       8,000       33,250       26,800  
Net interest income (loss) after provision for loan losses
    (15,368 )     4,655       (869 )     13,064  
                                 
Non-interest income
                               
Service charges on deposit accounts
    563       690       1,673       1,979  
Income from fiduciary activities
    261       237       803       738  
Bank card interchange fees
    180       168       553       500  
Other real estate owned rental income
    180       93       242       147  
Secondary market brokerage fees
    27       32       75       184  
Net gain on sales of loans originated for sale
    138       123       260       664  
Net gain on sales of securities
                3,530       1,108  
Other
    372       357       1,048       1,032  
      1,721       1,700       8,184       6,352  
Non-interest expense
                               
Salaries and employee benefits
    4,264       3,780       12,558       12,084  
Occupancy and equipment
    971       957       2,826       2,910  
Goodwill impairment
                      23,794  
Other real estate owned expense
    5,204       17,029       7,666       40,505  
FDIC Insurance
    559       930       2,264       2,640  
Loan collection expense
    792       802       1,738       1,989  
Professional fees
    776       329       1,699       963  
State franchise tax
    496       582       1,680       1,746  
Communications
    175       176       523       509  
Postage and delivery
    108       117       339       368  
Advertising
    44       93       105       282  
Other
    761       628       2,061       1,787  
      14,150       25,423       33,459       89,577  
Loss before income taxes
    (27,797 )     (19,068 )     (26,144 )     (70,161 )
Income tax benefit
    (65 )     (6,906 )     (65 )     (18,809 )
Net loss
    (27,732 )     (12,162 )     (26,079 )     (51,352 )
Less:
                               
Dividends on preferred stock
    437       437       1,312       1,312  
Accretion on Series A preferred stock
    44       45       134       133  
Earnings (losses) allocated to participating securities
    (1,264 )     (463 )     (1,095 )     (1,995 )
Net loss attributable to common shareholders
  $ (26,949 )   $ (12,181 )   $ (26,430 )   $ (50,802 )
Basic earnings (loss) per common share
  $ (2.29 )   $ (1.04 )   $ (2.25 )   $ (4.34 )
Diluted earnings (loss) per common share
  $ (2.29 )   $ (1.04 )   $ (2.25 )   $ (4.34 )
 
See accompanying notes to unaudited consolidated financial statements.
 
 
3

 
 
PORTER BANCORP, INC.
Unaudited Consolidated Statements of Comprehensive Loss
(in thousands)
 
   
Three Months Ended
September 30,
   
Nine Month Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net loss
  $ (27,732 )   $ (12,162 )   $ (26,079 )   $ (51,352 )
Other comprehensive income (loss), net of tax:                                
   Unrealized gain (loss) on securities:                                
      Unrealized gain (loss) arising in period                                
         (net of tax of $821, $676,                                 
         $970, and $1,681, respectively)
    1,525       1,257       1,803       3,122  
      Reclassification of amount realized through sales                                
         (net of tax of $0, $0,                                
         $1,235 and $388, respectively)
                (2,295 )     (720 )
      Net unrealized gain (loss) on securities
    1,525       1,257       (492 )     2,402  
                                 
Comprehensive loss
  $ (26,207 )   $ (10,905 )   $ (26,571 )   $ (48,950 )

 
See accompanying notes to unaudited consolidated financial statements.
 
 
4

 
 
PORTER BANCORP, INC.
Unaudited Consolidated Statement of Changes in Stockholders’ Equity
For Nine Months Ended September 30, 2012
(dollars in thousands, except share and per share data)
 
 
                                                    Accumulated        
      Shares       Amount    
Additional
          Other        
         
Series A
   
Series C
         
Series A
   
Series C
   
Paid-In
   
Retained
    Comprehensive        
   
Common
   
Preferred
   
Preferred
   
Common
   
Preferred
   
Preferred
   
Capital
   
Deficit
   
Income
   
Total
 
                                                             
Balances, January 1, 2012
    11,824,472       35,000       317,042     $ 112,236     $ 34,661     $ 3,283     $ 19,841     $ (91,656 )   $ 4,164     $ 82,529  
Issuance of unvested stock
    191,140                                                        
Forfeited unvested stock
    (8,485 )                                                      
Stock-based compensation
expense
                                        338                     338  
Net loss
                                              (26,079 )           (26,079 )
Net change in accumulated
other
comprehensive
income, net of taxes
                                                    (492 )     (492 )
Dividends 5% on Series A
preferred stock
                                              (1,312 )           (1,312 )
Accretion of Series A preferred
stock discount
                            134                   (134 )            
                                                                                 
Balances, September 30, 2012
    12,007,127       35,000       317,042     $ 112,236     $ 34,795     $ 3,283     $ 20,179     $ (119,181 )   $ 3,672     $ 54,984  

 
See accompanying notes to unaudited consolidated financial statements.
 
 
5

 
 
PORTER BANCORP, INC.
Unaudited Consolidated Statements of Cash Flows
For Nine Months Ended September 30, 2012 and 2011
(dollars in thousands)
 
    2012     2011  
Cash flows from operating activities
           
Net loss
  $ (26,079   $ (51,352 )
Adjustments to reconcile net loss to
  net cash from operating activities
               
Depreciation and amortization
    1,819       1,838  
Provision for loan losses
    33,250       26,800  
Net amortization on securities
    2,610       1,036  
Goodwill impairment charge
          23,794  
Stock-based compensation expense
    338       342  
Deferred income taxes (benefit)
          (11,047 )
Net gain on loans originated for sale
    (260 )     (664 )
Loans originated for sale
    (12,214 )     (21,682 )
Proceeds from sales of loans originated for sale
    12,910       21,851  
Net gain on sales of investment securities
    (3,530 )     (1,108 )
Net loss on sales of other real estate owned
    1,481       7,549  
Net write-down of other real estate owned
    5,090       30,702  
Earnings on bank owned life insurance
    (222 )     (224 )
Net change in accrued interest receivable and other assets
    5,075       (4,767 )
Net change in accrued interest payable and other liabilities
    4,027       27  
Net cash from operating activities
    24,295       23,095  
Cash flows from investing activities
Purchases of available-for-sale securities
    (141,232 )     (113,779 )
Sales of available-for-sale securities
    65,695       50,023  
Maturities and prepayments of available-for-sale securities
    36,649       15,018  
Proceeds from sale of other real estate owned
    17,032       9,323  
Improvements to other real estate owned
    (1 )     (1,596 )
Loan originations and payments, net
    120,958       51,793  
Purchases of premises and equipment, net
    (399 )     (324 )
Net cash from investing activities
    98,702       10,458  
Cash flows from financing activities                
Net change in deposits
    (146,236 )     (94,221 )
Net change in repurchase agreements
    665       (288 )
Repayment of Federal Home Loan Bank advances
    (1,156 )     (26,867 )
Advances from Federal Home Loan Bank
          25,000  
Repayment of subordinated capital note
    (450 )     (675 )
Cash dividends paid on preferred stock
          (1,319 )
Cash dividends paid on common stock
          (237 )
Net cash from financing activities
    (147,177 )     (98,607 )
Net change in cash and cash equivalents
    (24,180 )     (65,054 )
Beginning cash and cash equivalents
    105,962       185,435  
Ending cash and cash equivalents
  $ 81,782     $ 120,381  
Supplemental cash flow information:
               
Interest paid
  $ 11,808     $ 17,183  
Income taxes paid (refunded)
    (2,000 )     2,000  
Supplemental non-cash disclosure:                
Transfer from loans to other real estate
  $ 31,531     $ 31,232  
Financed sales of other real estate owned
    541       7,956  

 
See accompanying notes to unaudited consolidated financial statements.
 
 
6

 
 
PORTER BANCORP, INC.
Notes to Unaudited Consolidated Financial Statements


Note 1 – Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation – The consolidated financial statements include Porter Bancorp, Inc. (Company or PBI) and its subsidiary, PBI Bank (Bank).  The Company owns a 100% interest in the Bank. All significant inter-company transactions and accounts have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, the financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the entire year.  A description of other significant accounting policies is presented in the notes to the Consolidated Financial Statements for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K.

Use of Estimates – To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  The allowance for loan losses, fair values of financial instruments, stock compensation, deferred tax assets, other intangibles, and fair values of other real estate owned are particularly subject to change.

Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation. The reclassifications did not impact net income or stockholders’ equity.

New Accounting Standards – In July 2012, the FASB issued ASU No. 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment.” The provisions of ASU No. 2012-02 provide the option to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, it is concluded that it is not more likely than not that the indefinite-lived intangible asset is impaired, then no further action is required. However, if the conclusion is otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Subtopic 350-30. The provisions of this new guidance are effective for fiscal years beginning after September 15, 2012. The adoption of ASU No. 2012-02 is not expected to have a material impact on the Company’s statements of operations and condition.
 
Note 2 – Recent Developments and Future Plans
 
During the first nine months of 2012, we reported net loss to common shareholders of $26.4 million.  This loss was primarily attributable to $33.3 million of provision for loan losses expense due to continued decline in credit trends in our portfolio that resulted in net charge-offs of $31.8 million, OREO expense of $7.7 million resulting from fair value write-downs driven by new appraisals and reduced marketing prices, net loss on sales, and ongoing operating expense. We also had  lower net interest margin due to lower average loans outstanding, loans repricing at lower rates, and the level of non-performing loans in our portfolio. Net loss to common shareholders of $26.4 million, for the first nine months of 2012, compares with net loss to common shareholders of $50.8 million for the first nine months of 2011.
 
During the year ended December 31, 2011, we recorded a net loss to common shareholders of $105.2 million.  This loss was attributable to a $23.8 million goodwill impairment charge, the establishment of a $31.7 million valuation allowance on our deferred tax assets, OREO expense of $47.5 million related to valuation adjustments for our change in strategy related to certain properties, fair value write-downs related to new appraisals received for properties in the portfolio during 2011, net loss on the sale of OREO properties, and increase in carrying costs associated with carrying these higher levels of assets. We also recorded a provision for loan losses expense of $62.6 million due to the continued decline in credit trends within our portfolio.
 
 
7

 
 
In June 2011, the Bank agreed to a Consent Order with the FDIC and KDFI in which the Bank agreed, among other things, to improve asset quality, reduce loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%.  The Consent Order was included in our Current Report on 8-K filed on June 30, 2011. In October 2012, the Bank entered into a new Consent Order with the FDIC and KDFI again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a sufficient capital investment into the Bank to fully meet the capital requirements.
 
We expect to continue to work with our regulators toward capital ratio compliance as outlined in the written capital plan previously submitted by the Bank. The new Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. The new Consent Order was included in our Current Report on 8-K filed on September 19, 2012. As of September 30, 2012, the capital ratios required by the Consent Order were not met.
 
In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies to achieve the following objectives:
 
 
·
Continuing to operate the Company and Bank in a safe and sound manner.  This strategy will require us to continue to reduce the size of our balance sheet, reduce our lending concentrations, consider selling loans, and reduce other noninterest expense through the disposition of OREO.
 
 
·
Continuing with succession planning and adding resources to the management team.  In March 2012, the Board of Directors formed a search committee comprised of its five independent directors to identify and hire a President and CEO for PBI Bank.   John T. Taylor was named to these positions and appointed to the board of directors in July 2012.   Additionally, John R. Davis was appointed Chief Credit Officer of PBI Bank, with responsibility for establishing and executing the credit quality policies and overseeing credit administration for the organization.
 
 
·
Evaluating our internal processes and procedures, distribution of labor, and work-flow to ensure we have adequately and appropriately deployed resources in an efficient manner in the current environment.  To this end, we believe the opportunity exists for the centralization of key processes which will lead to improved execution and cost savings.
 
 
·
Raising capital by selling common stock through a public offering or private placement to existing and new investors.  At our 2012 annual meeting of shareholders, our shareholders approved an increase in our common shares authorized for issuance from 19 million shares to 86 million shares.  We continue to evaluate our opportunities to improve our capital structure and to increase common equity through the sale of additional common shares.  The Board of Directors has engaged an investment banking firm to assist in this evaluation and to explore options for the redemption of our Series A preferred stock issued to the US Treasury in 2008 under the Capital Purchase Program.
 
 
·
Executing on our commitment to improve credit quality and reduce loan concentrations and balance sheet risk.
 
 
o
We have reduced the size of our loan portfolio significantly from $1.3 billion at December 31, 2010 to $1.1 billion at December 31, 2011, and $952 million at September 30, 2012.   We have significantly improved our staffing in the commercial lending area which is now led by John R. Davis, who joined the team in August and now serves as Chief Credit Officer.
 
 
o
Our Consent Order calls for us to reduce our construction and development loans to not more than 75% of total risk-based capital. We were in compliance at September 30, 2012 with construction and development loans representing 75% of total risk-based capital.  These loans totaled $69.3 million, or 75% of total risk-based capital, at September 30, 2012 and $101.5 million, or 85% of total risk-based capital, at December 31, 2011.
 
 
8

 
 
 
o
Our Consent Order also requires us to reduce non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group, to not more than 250% of total risk-based capital.  While we have made significant improvements over the last year, we were not in compliance with this concentration limit at September 30, 2012.  These loans totaled $339.9 million, or 368% of total risk-based capital, at September 30, 2012 and $414.6 million, or 349% of total risk-based capital, at December 31, 2011.
 
 
o
We are working to reduce these loans by curtailing new construction and development lending and new non-owner occupied commercial real estate lending.  We are also receiving principal reductions from amortizing credits and pay-downs from our customers who sell properties built for resale.  We have reduced the construction loan portfolio from $199.5 million at December 31, 2010 to $69.3 million at September 30, 2012.  Our non-owner occupied commercial real estate loans declined from $293.3 million at December 31, 2010 to $214.5 million at September 30, 2012.
 
 
·
Executing on our commitment to sell other real estate owned and reinvest in quality income producing assets.
 
 
o
The remediation process for loans secured by real estate has led the Bank to acquire significant levels of OREO in 2010 and 2011.  This trend has continued into 2012.  The Bank acquired $90.8 million and $41.9 million during 2010 and 2011, respectively.  For the first nine months of 2012, we acquired $31.5 million of OREO.
 
 
o
We have incurred significant losses in disposing of this real estate.   We incurred losses totaling $13.9 million and $42.8 million in 2010 and 2011, respectively, from sales and fair value write-downs attributable to declining valuations as evidenced by new appraisals and from changes in our sales strategies.  During the nine month period ended September 30, 2012, we incurred OREO losses totaling $6.6 million, which consisted of $1.5 million in loss on sale and $5.1 million from declining values as evidenced by new appraisals and reduced marketing prices in connection with our sales strategies.
 
 
o
To ensure that we maximize the value we receive upon the sale of OREO, we continue to evaluate sales opportunities and channels.  We are targeting multiple sales opportunities and channels through internal marketing and the use of brokers, auctions, technology sales platforms, and bulk sale strategies.  Proceeds from the sale or OREO totaled $17.6 million during the nine months ended September 30, 2012 and $25.0 and $26.0 million during fiscal 2010 and 2011, respectively.
 
 
o
At December 31, 2011 the OREO portfolio consisted of 75% construction, development, and land assets.  At September 30, 2012 this concentration had declined to 54%.  This is consistent with our reduction of construction, development and other land loans,  which have declined to $69.3 million at September 30, 2012 compared to $101.5 million at December 31, 2011.  Over the past nine months, the composition of our OREO portfolio has shifted to be more heavily weighted towards commercial real estate properties with a cash flow opportunity and 1-4 family residential properties, which we have found to be more liquid than construction, development, and land assets.  Commercial real estate of this nature represents 31% of the portfolio at September 30, 2012 compared with 15% at December 31, 2011.  1-4 family residential properties represent 14% of the portfolio at September 30, 2012 compared with 7% at December 31, 2011.
 
 
·
Evaluating other strategic alternatives, such as the sale of assets or branches.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order.  Based on individual circumstances, the agencies may issue mandatory directives, impose monetary penalties, initiate changes in management, or take more serious adverse actions.
 
 
9

 
 
Note 3 Securities

The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
    (in thousands)  
September 30, 2012
                       
U.S. Government and federal agency
  $ 5,647     $ 556     $     $ 6,203  
Agency mortgage-backed: residential
    125,722       1,738       (293 )     127,167  
State and municipal
    51,663       2,431       (71 )     54,023  
Corporate bonds
    7,271       999             8,270  
Other
    572       23             595  
Total debt securities
    190,875       5,747       (364 )     196,258  
Equity
    1,359       531             1,890  
Total
  $ 192,234     $ 6,278     $ (364 )   $ 198,148  
 
December 31, 2011
  $ 10,494     $ 1,149     $     $ 11,643  
U.S. Government and federal agency
Agency mortgage-backed: residential
    97,286       2,211       (22 )     99,475  
State and municipal
    35,456       2,610       (4 )     38,062  
Corporate bonds
    7,259       315       (242 )     7,332  
Other
    572       34             606  
Total debt securities
    151,067       6,319       (268 )     157,118  
Equity
    1,359       356             1,715  
Total
  $ 152,426     $ 6,675     $ (268 )   $ 158,833  

Sales and calls of available for sale securities were as follows:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
     
2012
       2011        2012        2011  
   
(in thousands)
 
Proceeds
  $     $ 370     $ 65,695     $ 50,023  
Gross gains
                3,530       1,108  
Gross losses
     —        —        —        —  
 
The amortized cost and fair value of the debt investment securities portfolio are shown by contractual maturity.  Contractual maturities may differ from actual maturities if issuers have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities not due at a single maturity date are detailed separately.
 
   
September 30, 2012
 
   
Amortized
Cost
   
Fair
Value
 
   
(in thousands)
 
Maturity
               
Available-for-sale                 
Within one year
   879      909  
One to five years
    12,436       13,578  
Five to ten years
    42,412       44,838  
Beyond ten years
    9,426       9,766  
Agency mortgage-backed: residential
    125,722       127,167  
Total     $ 190,875     $ 196,258  
 
 
10

 
                                                                                                              
Securities pledged at September 30, 2012 and December 31, 2011 had carrying values of approximately $56.9 million and $57.7 million, respectively, and were pledged to secure public deposits and repurchase agreements.

The Company evaluates securities for other than temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, underlying credit quality of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the sector or industry trends and cycles affecting the issuer, and the results of reviews of the issuer’s financial condition.  Management currently intends to hold all securities with unrealized losses until recovery, which for fixed income securities may be at maturity.

At September 30, 2012, the Company held 40 equity securities.  Of these securities, one security had an unrealized loss less than $1,000 and had been in an unrealized loss position for less than twelve months. All other equity securities were in an unrealized gain position at September 30, 2012.  Management monitors the underlying financial condition of the issuers and current market pricing for these equity securities monthly. As of September 30, 2012, management does not believe any securities in our portfolio with unrealized losses should be classified as other than temporarily impaired. Management currently intends to hold all securities with unrealized losses until recovery, which for fixed income securities may be at maturity.

Securities with unrealized losses at September 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

   
Less than 12 Months
   
12 Months or More
   
Total
 
Description of Securities
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
   
(in thousands)
 
September 30, 2012
                                   
State and municipal
  $ 6,418     $ (71 )   $     $     $ 6,418     $ (71 )
Agency mortgage-backed: residential
    30,324       (293 )                 30,324       (293 )
Equity
    2                         2        
Total temporarily impaired
  $ 36,744     $ (364 )   $     $     $ 36,744     $ (364 )
                                                 
                                                 
December 31, 2011
                                               
State and municipal
  $ 508     $ (4 )   $     $     $ 508     $ (4 )
Agency mortgage-backed: residential
    2,159       (22 )                 2,159       (22 )
Corporate bonds
    2,805       (242 )                 2,805       (242 )
Total temporarily impaired
  $ 5,472     $ (268 )   $     $     $ 5,472     $ (268 )
 
 
11

 

Note 4 – Loans

 
 
 
 
Loans were as follows:
  September 30,      December 31,   
   
2012
   
2011
 
   
(in thousands)
 
Commercial
  $ 56,050     $ 71,216  
Commercial Real Estate:                 
Construction
    69,306       101,471  
Farmland
    84,426       90,958  
Other
    350,129       423,844  
Residential Real Estate:                 
Multi-family
    56,065       60,410  
1-4 Family
    287,613       337,350  
Consumer
    21,813       26,011  
Agriculture
    25,661       23,770  
Other
    748       993  
Subtotal
    951,811       1,136,023  
Less: Allowance for loan losses
    (54,019 )     (52,579 )
Loans, net
  $ 897,792     $ 1,083,444  
 
The following table presents the activity in the allowance for loan losses by portfolio segment for the three months ended September 30, 2012 and 2011:
 
   
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Agriculture
   
Other
   
Total
 
   
(in thousands)
 
September 30, 2012:
                                         
Beginning balance
  $ 3,811     $ 31,049     $ 15,587     $ 792     $ 343     $ 12     $ 51,594  
Provision for loan losses
    2,630       17,412       4,326       366       763       3       25,500  
Loans charged off
    (2,400 )     (16,192 )     (3,824 )     (375 )       (696           (23,487 )
Recoveries
    27       324       16       24       21             412  
Ending balance
  $ 4,068     $ 32,593     $ 16,105     $ 807     $ 431     $ 15     $ 54,019  
                                                         
                                                         
September 30, 2011:
                                                       
Beginning balance
  $ 2,668     $ 26,021     $ 9,260     $ 616     $ 143     $ 9     $ 38,717  
Provision for loan losses
    819       2,723       3,995       290       176       (3 )       8,000  
Loans charged off
    (764 )     (3,640 )     (2,560 )     (294 )     (109           (7,367 )
Recoveries
    15       99       8       20                   142  
Ending balance
  $ 2,738     $ 25,203     $ 10,703     $ 632     $ 210     $ 6     $ 39,492  
 
 
12

 

The following table presents the activity in the allowance for loan losses by portfolio segment for the nine months ended September 30, 2012 and 2011:
 
   
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Agriculture
   
Other
   
Total
 
   
(in thousands)
 
September 30, 2012:
                                         
Beginning balance
  $ 4,207     $ 33,024     $ 14,217     $ 792     $ 325     $ 14     $ 52,579  
Provision for loan losses
    2,641       19,187       9,528       687       1,206       1       33,250  
Loans charged off
    (2,866 )     (20,055 )     (7,715 )     (747 )       (1,124           (32,507 )
Recoveries
    86       437       75       75       24             697  
Ending balance
  $ 4,068     $ 32,593     $ 16,105     $ 807     $ 431     $ 15     $ 54,019  
                                                         
                                                         
September 30, 2011:
                                                       
Beginning balance
  $ 2,147     $ 24,075     $ 7,224     $ 701     $ 134     $ 4     $ 34,285  
Provision for loan losses
    3,251       14,144       8,702       508       193       2       26,800  
Loans charged off
    (2,699 )     (13,134 )     (5,253 )     (627 )     (117 )           (21,830 )
Recoveries
    39       118       30       50                   237  
Ending balance
  $ 2,738     $ 25,203     $ 10,703     $ 632     $ 210     $ 6     $ 39,492  
 
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of September 30, 2012:
 
   
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Agriculture
   
Other
   
Total
 
   
(in thousands)
 
Allowance for loan losses:
                                         
Ending allowance balance
attributable to loans:
                                         
Individually evaluated for
impairment
  $ 202     $ 10,242     $ 4,091     $     $ 9     $ 11     $ 14,555  
Collectively evaluated for
impairment
    3,866       22,351       12,014       807       422       4       39,464  
Total ending allowance
balance
  $ 4,068     $ 32,593     $ 16,105     $ 807     $ 431     $ 15     $ 54,019  
                                                         
                                                         
Loans:
                                                       
Loans individually evaluated
for impairment
  $ 3,671     $ 109,008     $ 58,012     $ 293     $ 82     $ 529     $ 171,595  
Loans collectively evaluated|
for impairment
    52,379       394,853       285,666       21,520       25,579       219       780,216  
Total ending loans balance
  $ 56,050     $ 503,861     $ 343,678     $ 21,813     $ 25,661     $ 748     $ 951,811  
 
 
13

 
 
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of December 31, 2011:
 
   
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Agriculture
   
Other
   
Total
 
   
(in thousands)
 
Allowance for loan losses:
                                         
Ending allowance balance
attributable to loans:
                                         
Individually evaluated for
impairment
  $ 554     $ 9,580     $ 2,172     $     $     $ 8     $ 12,314  
Collectively evaluated for
impairment
    3,653       23,443       12,045       792       326       6        40,265  
Total ending allowance
balance
  $ 4,207     $ 33,023     $ 14,217     $ 792     $ 326     $ 14     $ 52,579  
                                                         
                                                         
Loans:
                                                       
Loans individually evaluated
for impairment
  $ 5,032     $ 116,676     $ 27,848     $     $ 631     $ 540     $ 150,727  
Loans collectively evaluated
for impairment
    66,184       499,598       369,911       26,011       23,139       453       985,296  
Total ending loans balance
  $ 71,216     $ 616,274     $ 397,759     $ 26,011     $ 23,770     $ 993     $ 1,136,023  

In the current period, the allowance for loans subject to a troubled debt restructure is presented as individually evaluated for impairment.  Amounts presented in the preceding table have been reclassified to conform to our current period presentation because the allowance for loans subject to a troubled debt restructure had historically been presented as collectively evaluated for impairment.

Impaired Loans
 
Impaired loans include restructured loans and commercial, commercial real estate, construction, residential real estate, and agriculture loans, whereby collection of the total amount is improbable, or loss, whereby all or a portion of the loan has been written off or a specific allowance for loss had been provided.
 
The following table presents information related to loans individually evaluated for impairment by class of loans as of and for the three and nine months ended September 30, 2012:

                     
Three Months Ended
September 30, 2012
   
Nine Months Ended
September 30, 2012
 
   
Unpaid
Principal
Balance
   
Recorded Investment
   
Allowance
For Loan
Losses
Allocated
   
Average Recorded Investment
   
Interest
Income Recognized
   
Average Recorded Investment
   
Interest
Income Recognized
   
Cash
Basis
Income
Recognized
 
   
(in thousands)
 
With No Related Allowance Recorded:
                                               
Commercial
  $ 1,641     $ 1,434     $     $ 1,539     $     $ 1,738     $     $  
Commercial real estate:
                                                               
Construction
    1,240       1,195             1,525             1,904       2       1  
Farmland
    5,585       5,584             5,594             4,771       5       5  
Other
    2,981       2,606             3,424             3,822       3       3  
Residential real estate:
                                                               
Multi-family
    997       997             1,212             977              
1-4 Family
    15,797       15,152             13,888       15       10,824       42       42  
Consumer
    292       292             312       1       256       4       2  
Agriculture
    61       61             324             447              
Other
                                               
 
 
14

 

                     
Three Months Ended
September 30, 2012
   
Nine Months Ended
September 30, 2012
 
   
Unpaid
Principal
Balance
   
Recorded Investment
   
Allowance
For Loan
Losses
Allocated
   
Average Recorded Investment
   
Interest
Income Recognized
   
Average Recorded Investment
   
Interest
Income Recognized
   
Cash
Basis
Income
Recognized
 
    (in thousands)   
With An Allowance Recorded:
                                                 
Commercial
    2,237       2,237       202       3,686       32       3,940       120       27  
Commercial real estate:
                                                               
Construction
    12,713       11,668       1,530       15,103       106       18,028       302       4  
Farmland
    5,680       5,479       524       5,272       14       5,629       32       2  
Other
    85,080       82,477       8,188       81,108       777       82,219       1,636       185  
Residential real estate:
                                                               
Multi-family
    14,691       14,691       1,158       12,010       207       10,257       348        
1-4 Family
    28,269       27,172       2,933       28,084       218       27,232       620       9  
Consumer
                                               
Agriculture
    21       21       9       11             5              
Other
    529       529       11       531       4       534       13        
Total
  $ 177,814     $ 171,595     $ 14,555     $ 173,623     $ 1,374     $ 172,583     $ 3,127     $ 280  

The following table presents loans individually evaluated for impairment by class of loan as of December 31, 2011:

   
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
For Loan
Losses
Allocated
   
Average
Recorded
Investment
   
Interest
 Income
Recognized
   
Cash
Basis
 Income
Recognized
 
   
(in thousands)
       
With No Related Allowance Recorded:
                                   
Commercial
  $ 1,868     $ 1,825     $     $ 1,984     $ 26     $ 26  
Commercial real estate:
                                               
Construction
    1,121       1,193             7,584       7       5  
Farmland
    3,302       3,218             2,218       36       36  
Other
    6,039       5,640             12,114       169       99  
Residential real estate:
                                               
Multi-family
                                   
1-4 Family
                      1,351       34        
Consumer
                                   
Agriculture
    637       631             253       5       5  
Other
                                   
With An Allowance Recorded:
                                               
Commercial
    3,207       3,207       554       2,630       189       90  
Commercial real estate:
                                               
Construction
    23,175       20,174       4,275       6,090       143        
Farmland
    7,303       6,862       574       6,487       322        
Other
    85,535       79,859       4,731       36,583       899       148  
Residential real estate:
                                               
Multi-family
    4,795       4,316       558       2,824       150        
1-4 Family
    26,225       23,262       1,614       15,105       614       3  
Consumer
                                   
Agriculture
                                   
Other
    540       540       8       108              
Total
  $ 163,747     $ 150,727     $ 12,314     $ 95,331     $ 2,594     $ 412  
 
 
15

 

Troubled Debt Restructuring
 
A troubled debt restructuring (TDR) is where the Company has agreed to a loan modification in the form of a concession for a borrower who is experiencing financial difficulty.  The majority of the Company’s TDRs involve a reduction in interest rate, a deferral of principal for a stated period of time, or an interest only period.  All TDRs are considered impaired and the Company has allocated reserves for these loans to reflect the present value of the concessionary terms granted to the customer.

The following table presents the types of TDR loan modifications by portfolio segment outstanding as of September 30, 2012 and December 31, 2011:
 
   
TDRs
Performing to
Modified Terms
   
TDRs Not
Performing to
Modified Terms
   
Total
TDRs
 
   
(in thousands)
 
September 30, 2012
                 
Commercial
                 
Rate reduction
  $     $ 213     $ 213  
Principal deferral
    889             889  
Interest only payments
          1,019       1,019  
Commercial Real Estate:
                       
Construction
                       
Rate reduction
    7,407       2,337       9,744  
Farmland
                       
Rate reduction
    150             150  
Principal deferral
    729       2,483       3,212  
Other
                       
Rate reduction
    36,818       21,886       58,704  
Principal deferral
    1,196             1,196  
Interest only payments
    2,467       2,174       4,641  
Residential Real Estate:
                       
Multi-family
                       
Rate reduction
    13,133       31       13,164  
Interest only payments
    655             655  
1-4 Family
                       
Rate reduction
    17,957       5,025       22,982  
Principal deferral
          384       384  
Other
                       
Rate reduction
    529             529  
Total TDRs
  $ 81,930     $ 35,552     $ 117,482  

   
TDRs
Performing to
Modified Terms
   
TDRs Not
Performing to
Modified Terms
   
Total
TDRs
 
   
(in thousands)
 
December 31, 2011
                 
Commercial
                 
Rate reduction
  $ 1,231     $     $ 1,231  
Principal deferral
    898             898  
Commercial Real Estate:
                       
Construction
                       
Rate reduction
    11,155       3,767       14,922  
Interest only payments
          1,404       1,404  
Farmland
                       
Rate reduction
    182             182  
Principal deferral
    746       5,101       5,847  
Other
                       
Rate reduction
    42,946       20,446       63,392  
Interest only payments
    1,288             1,288  
Residential Real Estate:
                       
Multi-family
                       
Rate reduction
    2,247       1,413       3,660  
Interest only payments
    656             656  
1-4 Family
                       
Rate reduction
    12,255       7,176       19,431  
Principal deferral
          247       247  
Other
                       
Rate reduction
    540             540  
Total TDRs
  $ 74,144     $ 39,554     $ 113,698  
 
 
16

 
 
At September 30, 2012, and December 31, 2011, 70% and 65%, respectively, of the Company’s TDRs were performing according to their modified terms.  The Company allocated $11.7 million and $10.6 million in reserves to customers whose loan terms have been modified in TDRs as of September 30, 2012, and December 31, 2011, respectively.  The Company has committed to lend additional amounts totaling $358,000 and $317,000 as of September 30, 2012, and December 31, 2011, respectively, to customers with outstanding loans that are classified as TDRs.

The following table presents a summary of the types of TDR loan modifications by portfolio type that occurred during the three months ended September 30, 2012:
 
   
TDRs
Performing to
Modified Terms
   
TDRs Not
Performing to
Modified Terms
   
Total
TDRs
 
   
(in thousands)
 
September 30, 2012
                 
Commercial Real Estate:
       
 
   
 
 
Farmland
                 
Rate reduction
  $ 150     $     $ 150  
Other
                       
Rate reduction
    5,549             5,549  
Total TDRs
  $ 5,699     $     $ 5,699  

As of September 30, 2012, 100% of the Company’s TDRs that occurred during the three months ended September 30, 2012, were performing in accordance with their modified terms.  The Company has allocated $489,000 in reserves to customers whose loan terms have been modified during the three months ended September 30, 2012. For modifications occurring during the three month period ended September 30, 2012, the post- modification balances approximate the pre-modification balances.
 
 
17

 

The following table presents a summary of the types of TDR loan modifications by portfolio type that occurred during the nine months ended September 30, 2012:
 
   
TDRs
Performing to
Modified Terms
   
TDRs Not
Performing to
Modified Terms
   
Total
TDRs
 
   
(in thousands)
 
September 30, 2012
                 
Commercial
                 
Interest only payments
  $     $ 1,019     $ 1,019  
Commercial Real Estate:
                       
Construction
                       
 Rate reduction
          849       849  
Farmland
                       
Rate reduction
    150             150  
Other
                       
Rate reduction
    16,700             16,700  
Principal deferral
    1,196             1,196  
Interest only payments
    2,467       2,174       4,641  
Residential Real Estate:
                       
Multi-family
                       
Rate reduction
    12,848       31       12,879  
1-4 Family
                       
Rate reduction
    7,440             7,440  
Principal deferral
          384       384  
Total TDRs
  $ 40,801     $ 4,457     $ 45,258  
 
As of September 30, 2012, 90% of the Company’s TDRs that occurred during the first nine months of 2012 were performing in accordance with their modified terms.  The Company has allocated $3.9 million in reserves to customers whose loan terms have been modified during the first nine months of 2012. For modifications occurring during the nine month period ended September 30, 2012, the post-modification balances approximate the pre-modification balances.

During the first nine months of 2012, approximately $9.9 million TDRs defaulted on their restructured loan and the default occurred within the 12 month period following the loan modification. These defaults consisted of $6.9 million in commercial real estate loans, $1.2 million in commercial loans, and $1.7 million in 1-4 family residential real estate loans. A default is considered to have occurred once the TDR is past due 90 days or more or it has been placed on nonaccrual.

Nonperforming Loans

Nonperforming loans include impaired loans not on accrual and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment.
 
 
18

 
 
The following table presents the recorded investment in nonaccrual and loans past due 90 days and still on accrual by class of loan as of September 30, 2012, and December 31, 2011:
 
   
Nonaccrual
   
Loans Past
Due 90 Days
And Over Still
Accruing
 
   
September 30,
2012
   
December 31,
2011
   
September 30,
2012
   
December 31,
2011
 
   
(in thousands)
 
                         
Commercial
  $ 2,783     $ 2,903     $ 367     $ 109  
Commercial Real Estate:
                               
Construction
    5,456       13,564              
Farmland
    10,184       9,152             26  
Other
    44,497       35,154       1,119       918  
Residential Real Estate:
                               
Multi-family
    1,900       2,921              
1-4 Family
    23,501       27,375             265  
Consumer
    229       320              
Agriculture
    82       631             32  
Total
  $ 88,632     $ 92,020     $ 1,486     $ 1,350  
 
The following table presents the aging of the recorded investment in past due loans as of September 30, 2012 and December 31, 2011:
 
   
30 – 59
Days
Past Due
   
60 – 89
Days
Past Due
   
90 Days
And Over
Past Due
   
 
 
Nonaccrual
   
Total
Past Due
And
Nonaccrual
 
   
(in thousands)
 
September 30, 2012
                             
Commercial
  $ 909     $ 133     $ 367     $ 2,783     $ 4,192  
Commercial Real Estate:
                                       
Construction
    326       280             5,456       6,062  
Farmland
    695       1,339             10,184       12,218  
Other
    4,555       1,003       1,119       44,497       51,174  
Residential Real Estate:
                                       
Multi-family
    438                   1,900       2,338  
1-4 Family
    2,300       775             23,501       26,576  
Consumer
    394       30             229       653  
Agriculture
    9       8             82       99  
Total
  $ 9,626     $ 3,568     $ 1,486     $ 88,632     $ 103,312  

 
19

 
 
   
30 – 59
Days
Past Due
   
60 – 89
Days
Past Due
   
90 Days
And Over
Past Due
   
 
 
Nonaccrual
   
Total
Past Due
And
Nonaccrual
 
   
(in thousands)
 
December 31, 2011
                             
Commercial
  $ 2,792     $ 91     $ 109     $ 2,903     $ 5,895  
Commercial Real Estate:
                                       
Construction
    20                   13,564       13,584  
Farmland
    1,353       305       26       9,152       10,836  
Other
    4,555       756       918       35,154       41,383  
Residential Real Estate:
                                       
Multi-family
    442       135             2,921       3,498  
1-4 Family
    7,568       2,511       265       27,375       37,719  
Consumer
    593       149             320       1,062  
Agriculture
    23             32       631       686  
Total
  $ 17,346     $ 3,947     $ 1,350     $ 92,020     $ 114,663  
 
Credit Quality Indicators – We categorize loans into risk categories at origination based upon original underwriting. Subsequent to origination, we categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  Loans are analyzed individually by classifying the loans as to credit risk.  This analysis includes loans with an outstanding balance greater than $500,000 and non-homogeneous loans, such as commercial and commercial real estate loans.  This analysis is performed on a quarterly basis.  We do not have any non-rated loans. The following definitions are used for risk ratings:
 
Watch – Loans classified as watch are those loans which have experienced a potentially adverse development which necessitates increased monitoring.
 
Special Mention – Loans classified as special mention do not have all of the characteristics of substandard or doubtful loans. They have one or more deficiencies which warrant special attention and which corrective action, such as accelerated collection practices, may remedy.
 
Substandard – Loans classified as substandard are those loans with clear and defined weaknesses such as a highly leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition which may jeopardize the repayment of the debt as contractually agreed. They are characterized by the distinct possibility that we will sustain some losses if the deficiencies are not corrected.
 
Doubtful – Loans classified as doubtful are those loans which have characteristics similar to substandard loans but with an increased risk that collection or liquidation in full is highly questionable and improbable.
 
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be “Pass” rated loans.  As of September 30, 2012, and December 31, 2011, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
 
20

 

   
Pass
   
Watch
   
Special
Mention
   
Substandard
   
Doubtful
   
Total
 
   
(in thousands)
 
September 30, 2012
                                   
Commercial
  $ 35,084     $ 11,097     $ 1,988     $ 7,815     $ 66     $ 56,050  
Commercial Real Estate:
                                               
Construction
    27,007       19,914       5,951       16,434             69,306  
Farmland
    53,569       11,359       3,006       16,492             84,426  
Other
    147,379       72,837       30,017       99,593       303       350,129  
Residential Real Estate:
                                               
Multi-family
    22,888       14,752       1,359       17,066             56,065  
1-4 Family
    175,987       42,051       4,636       64,929       10       287,613  
Consumer
    18,979       1,796       83       892       63       21,813  
Agriculture
    23,460       866       810       525             25,661  
Other
    219       529                         748  
Total
  $ 504,572     $ 175,201     $ 47,850     $ 223,746     $ 442     $ 951,811  

   
Pass
   
Watch
   
Special
Mention
   
Substandard
   
Doubtful
   
Total
 
   
(in thousands)
 
December 31, 2011
                                   
Commercial
  $ 53,223     $ 9,357     $ 3,237     $ 5,300     $ 99     $ 71,216  
Commercial Real Estate:
                                               
Construction
    45,407       13,132       7,777       35,155             101,471  
Farmland
    69,881       4,955       2,688       13,236       199       90,959  
Other
    213,406       80,149       30,787       99,502             423,844  
Residential Real Estate:
                                               
Multi-family
    37,807       4,619       2,100       15,884             60,410  
1-4 Family
    247,422       28,734       2,276       58,891       26       337,349  
Consumer
    23,721       1,418       43       762       67       26,011  
Agriculture
    22,502       343       14       911             23,770  
Other
    453       540                         993  
Total
  $ 713,822     $ 143,247     $ 48,922     $ 229,641     $ 391     $ 1,136,023  
 
Note 5 – Other Real Estate Owned
 
Other real estate owned (OREO) is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure.  It is classified as real estate owned until such time as it is sold.  When property is acquired as a result of foreclosure or by deed in lieu of foreclosure, it is recorded at its fair market value less cost to sell.  Any write-down of the property at the time of acquisition is charged to the allowance for loan losses.  Subsequent reductions in fair value are recorded as non-interest expense.  To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers.  If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are taken.
 
For larger dollar residential and commercial real estate properties, we obtain a new appraisal of the subject property in connection with the transfer to other real estate owned.  We obtain updated appraisals each year on the anniversary date of ownership unless a sale is imminent. 

We continue to explore opportunities to sell OREO properties in bulk. In 2011, as a result of adopting a strategy to more aggressively market our OREO properties, we determined that we would be willing to sell certain OREO properties at an amount below their individual appraised values. Accordingly, we adjusted our valuations for these properties downward by increasing their valuation allowances to reflect our more aggressive disposition strategy. These properties are primarily single and multi-family residential land development properties. The following table presents the major categories of OREO at the period-ends indicated:
 
 
21

 

   
September 30,
2012
   
December 31,
2011
 
   
(in thousands)
 
Commercial Real Estate:
           
Construction
  $ 27,262     $ 32,538  
Farmland
    415       744  
Other
    15,806       6,620  
Residential Real Estate:
               
1-4 Family
    7,149       3,214  
                 
      50,632       43,116  
Valuation allowance
    (1,795 )     (1,667 )
                 
    $ 48,837     $ 41,449  
 
   
For the Three
Months Ended
September 30,
   
For the Nine
Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
OREO Valuation Allowance Activity:
                       
Beginning balance
  $ 1,724     $ 10,643     $ 1,667     $ 700  
Provision to allowance
    4,260       15,265       5,090       30,702  
Write-downs
    (4,189 )     (4,154 )     (4,962 )     (9,648 )
Ending balance
  $ 1,795     $ 21,754     $ 1,795     $ 21,754  
 
Net activity relating to other real estate owned during the nine months ended September 30, 2012 and 2011 is as follows:

   
2012
   
2011
 
   
(in thousands)
 
OREO Activity
           
OREO as of January 1
  $ 41,449     $ 67,635  
Real estate acquired
    31,531       31,232  
Valuation adjustments
    (5,090 )     (30,702 )
Improvements
    1       1,596  
Loss on sale
    (1,481 )     (7,549 )
Proceeds from sale of properties
    (17,573 )     (17,279 )
OREO as of September 30
  $ 48,837     $ 44,933  
 
Expenses related to other real estate owned include:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Net loss on sales
  $ 533     $ 673     $ 1,481     $ 7,549  
Provision to allowance
    4,260       15,265       5,090       30,702  
Operating expense
    411       1,091       1,095       2,254  
Total
  $ 5,204     $ 17,029     $ 7,666     $ 40,505  
 
 
22

 
 
Note 6 – Deposits
 
Time deposits of $100,000 or more were $422.1 million and $493.3 million at September 30, 2012 and December 31, 2011, respectively.
 
Scheduled maturities of total time deposits at September 30, 2012 for each of the next five years are as follows (in thousands):
 
   
Retail
   
Brokered
   
Total
 
Year 1
  $ 422,755     $ 104,073     $ 526,828  
Year 2
    91,532             91,532  
Year 3
    226,500             226,500  
Year 4
    26,579             26,579  
Year 5
    10,775             10,775  
Thereafter
    89             89  
    $ 778,230     $ 104,073     $ 882,303  

Historically, the Bank has utilized brokered and wholesale deposits to supplement its funding strategy. At September 30, 2012, and December 31, 2011, these deposits totaled $104.1 million and $118.4 million, respectively. As stipulated in the Consent Order, PBI Bank is currently restricted from accepting, renewing, or rolling-over brokered deposits without the prior receipt of a waiver on a case-by-case basis from our regulators. Management intends to redeem brokered deposits at maturity.

Note 7 – Advance from the Federal Home Loan Bank

Advances from the Federal Home Loan Bank were as follows:
 
   
September 30,
   
December 31,
 
   
2012
   
2011
 
   
(in thousands)
 
Monthly amortizing advances with fixed rates from 0.00% to 5.25% and
           
maturities ranging from 2013 through 2033, averaging 3.24% for 2012
  $ 5,960     $ 7,116  
 
Each advance is payable per terms on agreement, with a prepayment penalty.  The advances were collateralized by first mortgage loans.  The borrowing capacity is based on the market value of the underlying pledged loans. At September 30, 2012, our additional borrowing capacity with the FHLB was $19.9 million. The availability of our borrowing capacity could be affected by our financial position and the FHLB could require additional collateral or, among other things, exercise its right to deny a funding request, at its discretion. Additionally, any new advances are limited to a one year maturity or less.

Note 8 – Fair Values Measurement

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We use various valuation techniques to determine fair value, including market, income and cost approaches.  There are three levels of inputs that may be used to measure fair values:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that an entity has the ability to access as of the measurement date, or observable inputs.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
 
 
23

 

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy.  When that occurs, we classify the fair value hierarchy on the lowest level of input that is significant to the fair value measurement.  We used the following methods and significant assumptions to estimate fair value.

Securities: The fair values of securities are determined by market quoted prices, if available (Level 1).  For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities, or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2).  For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).  Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Impaired Loans: An impaired loan is evaluated at the time the loan is identified as impaired and is recorded at fair value less costs to sell. Fair value is measured based on the value of the collateral securing the loan and is classified as Level 3 in the fair value hierarchy. Fair value is determined using several methods. Generally, the fair value of real estate is determined based on appraisals by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. These routine adjustments are made to adjust the value of a specific property relative to comparable properties for variations in qualities such as location, size, and income production capacity relative to the subject property of the appraisal. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.
 
We routinely apply an internal discount to the value of appraisals used in the fair value evaluation of our impaired loans. The deductions to the appraisal take into account changing business factors and market conditions, as well as potential value impairment in cases where the date of the appraisal of the collateral predates a likely change in market conditions.   These deductions range from 10% for routine real estate collateral to 25% for real estate that is determined (1) to have a thin trading market or (2) to be for unique use.  This is in addition to estimated discounts for cost to sell of ten percent.

We also apply discounts to the expected fair value of collateral for impaired loans where the likely resolution involves litigation of foreclosure. Resolution of this nature generally results in receiving lower values for real estate collateral in a more aggressive sales environment. We have utilized discounts ranging from 10% to 33% in our impairment evaluations when applicable.

Impaired loans are evaluated quarterly for additional impairment. We obtain updated appraisals on properties securing our loans when circumstances are warranted such as at the time of renewal or when market conditions have significantly changed. This determination is made on a property-by-property basis in light of circumstances in the broader economic climate and our assessment of deterioration of real estate values in the market in which the property is located.  The first stage of our assessment involves management’s inspection of the property in question.  Management also engages in conversations with local real estate professionals, investors, and market makers to determine the likely marketing time and value range for the property.  The second stage involves an assessment of current trends in the regional market.  After thorough consideration of these factors, management will either internally evaluate fair value or order a new appraisal.

Other Real Estate Owned (OREO): OREO is evaluated at the time of acquisition and recorded at fair value as determined by independent appraisal or internal market evaluation less cost to sell.  Our quarterly evaluations of OREO for impairment are driven by property type.  For smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers.  Based on these consultations, we determine asking prices for OREO properties we are marketing for sale. If the internally evaluated fair value is below our recorded investment in the property, appropriate write-downs are taken.
 
 
24

 

For larger dollar commercial real estate properties, we obtain a new appraisal of the subject property in connection with the transfer to other real estate owned.  In some of these circumstances, an appraisal is in process at quarter end, and we must make our best estimate of fair value based on our internal evaluation of the property, review of the most recent appraisal, and discussions with the currently engaged appraiser.  We obtain updated appraisals on the anniversary date of ownership unless a sale is imminent.

We routinely apply an internal discount to the value of appraisals used in the fair value evaluation of our OREO. The deductions to the appraisal take into account changing business factors and market conditions, as well as potential value impairment in cases where our appraisal date predates a likely change in market conditions.   These deductions range from 10% for routine real estate to 25% for real estate that is determined (1) to have a thin trading market or (2) to be for unique use.  This is in addition to estimated discounts for cost to sell of ten percent.

Given our change in strategy in 2011 to reduce non-performing assets in an accelerated manner, management adjusted downward the valuations for single and multi-family residential loan development properties in our OREO portfolio to amounts below their individual appraised values.


Financial assets measured at fair value on a recurring basis at September 30, 2012 are summarized below:
 
         
Fair Value Measurements at September 30, 2012 Using
 
         
(in thousands)
 
         
Quoted Prices In
         
Significant
 
         
Active Markets for
   
Significant Other
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Observable Inputs
   
Inputs
 
Description
 
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
   
Available-for-sale securities
                       
U.S. Government and
                       
federal agency
  $ 6,203     $     $ 6,203     $  
Agency mortgage-backed:
                               
residential
    127,167             127,167        
State and municipal
    54,023             54,023        
Corporate bonds
    8,270             8,270        
Other debt securities
    595                   595  
Equity securities
    1,890       1,890              
Total
  $ 198,148     $ 1,890     $ 195,663     $ 595  

There were no transfers between Level 1 and Level 2 during 2012 or 2011.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended September 30, 2012 and 2011:

   
State and Municipal
Securities
   
Other Debt
Securities
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands)
 
Balances of recurring Level 3 assets at January 1
  $ 1,173     $     $ 606     $ 572  
Total gain (loss) for the period:
                               
Included in other comprehensive income (loss)
                (11 )     45  
Sales
    (1,173 )                  
Balance of recurring Level 3 assets at September 30
  $     $     $ 595     $ 617  

Level 3 state and municipal securities valuations are supported by analysis prepared by an independent third party.  Their approach to determining fair value involves using recently executed transactions for similar securities and market quotations for similar securities. As securities of this type are not rated by the rating agencies and trading volumes are thin, it was determined that these were valued using Level 3 inputs. We sold our Level 3 municipal securities in the second quarter of 2012 and had no securities of this nature at September 30, 2012.
 
 
25

 

Our other debt security valuation is determined internally by calculating discounted cash flows using the security’s coupon rate of 6.5% and an estimated current market rate of 11.0% based upon the current yield curve plus spreads that adjust for volatility, credit risk, and optionality.  We also consider the issuer(s) publicly filed financial information as well as assumptions regarding the likelihood of deferrals and defaults.

Financial assets measured at fair value on a non-recurring basis at September 30, 2012 are summarized below:
 
         
Fair Value Measurements at September 30, 2012 Using
 
         
(in thousands)
 
         
Quoted Prices In
         
Significant
 
         
Active Markets for
   
Significant Other
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Observable Inputs
   
Inputs
 
Description
 
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
   
Impaired loans:
                       
Commercial
                       
Commercial real estate:
  $ 2,035     $     $     $ 2,035  
Construction
                               
Farmland
    10,138                   10,138  
Other
    4,955                   4,955  
Residential Real Estate
    74,289                   74,289  
Multi-family
                               
1-4 Family
    13,533                   13,533  
Agriculture
    24,239                   24,239  
Other      12        —        —        12  
Other real estate owned, net:      518        —        —        518  
Commerical real estate:                                
Construction       26,296        —        —        26,296  
Farmland       400        —        —        400  
Other       15,246        —        —        15,246  
Residential real estate:                                 
1-4 Family      6,895        —        —        6,895  
 
Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $144.3 million, with a valuation allowance of $14.6 million, at September 30, 2012, resulting in an additional provision for loan losses of $972,000 for the nine months ended September 30, 2012.
 
Other real estate owned, which is measured at the lower of carrying or fair value less estimated costs to sell, had a net carrying amount of $48.8 million as of September 30, 2012, compared with $44.9 million at September 30, 2011.  Fair value write-downs of $5.1 million and $30.7 million were recorded on other real estate owned for the first nine months of 2012 and 2011, respectively.
 
 
26

 

The following table presents qualitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2012:
 
     
Fair Value
 
Valuation
Technique(s)
 
Unobservable Input(s)
 
Range (Weighted
Average)
     
(in thousands)
           
                   
Impaired loans –
Commercial
 
1,345
 
Market  value approach
 
Adjustment for receivables and
inventory discounts
 
20% - 75% (48%)
                   
Impaired loans –
Commercial real
estate
 
50,442
 
Sales comparison approach
 
 
Adjustment for differences between the
comparable
sales
 
 
0% - 62% (23%)
 
                   
Impaired loans –
Residential real
estate
 
11,794
 
Sales comparison approach
 
 
Adjustment for differences between the
comparable
sales
 
 
3% - 38% (15%)
 
 
                   
Other real estate owned –
Commercial real
estate
  $
41,942
 
Sales comparison approach
Income approach
 
 
Adjustment for differences between the
comparable
sales
Discount or capitalization rate
Accelerated sales strategy
 
3% - 38% (18%)
9% - 16% (12%)
25% - 50% (35%)
                   
Other real estate owned –
Residential real
estate
 
6,895
 
Sales comparison approach
 
 
Adjustment for differences between the
comparable
sales
 
 
2% - 31% (12%)
 
 

Financial assets measured at fair value on a recurring basis at December 31, 2011 are summarized below:
 
 
         
Fair Value Measurements at December 30, 2011 Using
 
         
(in thousands)
 
         
Quoted Prices In
         
Significant
 
         
Active Markets for
   
Significant Other
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Observable Inputs
   
Inputs
 
Description
 
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
   
Available-for-sale securities
                       
U.S. Government and
                       
federal agency
  $ 11,643     $     $ 11,643     $  
Agency mortgage-backed:
    99,475             99,475        
State and municipal
    38,062             36,889       1,173  
Corporate bonds
    7,332             7,332        
Other debt securities
    606                   606  
Equity securities
    1,715       1,715              
Total
  $ 158,833     $ 1,715     $ 155,339     $ 1,779  

 
27

 

Financial assets measured at fair value on a non-recurring basis at December 31, 2011 are summarized below:
 
         
Fair Value Measurements at December 31, 2011 Using
 
         
(in thousands)
 
         
Quoted Prices In
         
Significant
 
         
Active Markets for
   
Significant Other
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Observable Inputs
   
Inputs
 
Description
 
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
   
Impaired loans:
                       
Commercial
                       
Commercial real estate:
  $ 2,653     $     $     $ 2,653  
Construction
                               
Farmland
    15,899                   15,899  
Other
    6,288                   6,288  
Residential Real Estate
    75,128                   75,128  
Multi-family
                               
1-4 Family
    3,758                   3,758  
Other      21,648        —        —        21,648  
Other real estate owned, net:      532        —        —        532  
Commerical real estate:                                
Construction       31,280        —        —        31,280  
Farmland       715        —        —        715  
Other       6,364        —        —       6,364  
Residential real estate:                                 
1-4 Family      3,090        —        —        3,090  
 
Impaired loans, which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying amount of $73.9 million with a valuation allowance of $5.6 million as of December 31, 2011.

Other real estate owned, which is measured at the lower of carrying or fair value less estimated costs to sell, had a net carrying amount of $41.4 million as of December 31, 2011.

Carrying amount and estimated fair values of financial instruments were as follows for the periods indicated:

         
Fair Value Measurements at September 30, 2012 Using
 
   
Carrying
Amount
   
Level 1
   
Level 2
   
Level 3
   
Total
 
   
(in thousands)
 
Financial assets
                             
Cash and cash equivalents
  $ 81,782     $ 71,524     $ 10,258     $     $ 81,782  
Securities available for sale
    198,148       1,890       195,663       595       198,148  
Federal Home Loan Bank stock
    10,072       N/A       N/A       N/A       N/A  
Mortgage loans held for sale
    210             210             210  
Loans, net
    897,792                   909,621       909,621  
Accrued interest receivable
    5,396             1,212       4,184       5,396  
Financial liabilities
                                       
Deposits
  $ 1,177,527     $ 111,403     $ 1,072,182     $     $ 1,183,585  
Securities sold under agreements to repurchase
    2,403             2,403             2,403  
Federal Home Loan Bank advances
    5,960             5,927             5,927  
Subordinated capital notes
    7,200                   6,800       6,800  
Junior subordinated debentures
    25,000                   19,617       19,617  
Accrued interest payable
    2,096             1,325       771       2,096  
 
 
28

 
 
   
Fair Value Measurements at
December 31, 2011
 
   
Carrying
Amount
   
Fair
Value
 
             
Financial assets
           
Cash and cash equivalents
  $ 105,962     $ 105,962  
Securities available for sale                                                                                              
    158,833       158,833  
Federal Home Loan Bank stock                                                                                              
    10,072       N/A  
Mortgage loans held for sale                                                                                              
    694       694  
Loans, net                                                                                              
    1,083,444       1,093,456  
Accrued interest receivable                                                                                              
    6,682       6,682  
Financial liabilities
               
Deposits
  $ 1,323,763     $ 1,332,133  
Securities sold under agreements to repurchase
    1,738       1,738  
Federal Home Loan Bank advances
    7,116       7,015  
Subordinated capital notes
    7,650       7,110  
Junior subordinated debentures
    25,000       19,765  
Accrued interest payable
    1,732       1,732  

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

(a) Cash and Cash Equivalents
The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. Noninterest bearing deposits are Level 1 whereas interest bearing due from bank accounts and fed funds sold are Level 2.

(b) FHLB Stock
It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(c) Loans, Net
Fair values of loans, excluding loans held for sale, are estimated as follows:  For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification.  Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) Mortgage Loans Held for Sale
The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

(e) Deposits
The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date resulting in either a Level 1 classification. The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in either a Level 1 classification.  Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(f) Securities Sold Under Agreements to Repurchase
The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification.
 
 
29

 

(g) Other Borrowings
The fair values of the Company’s FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

The fair values of the Company’s subordinated capital notes and junior subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(h) Accrued Interest Receivable/Payable
The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.

Note 9 – Income Taxes
 
Deferred tax assets and liabilities were due to the following as of:

   
September 30,
   
December 31,
 
   
2012
   
2011
 
   
(in thousands)
 
Deferred tax assets:
           
Allowance for loan losses
  $ 18,907     $ 18,403  
Other real estate owned write-down
    10,182       12,905  
Net operating loss carry-forward
    13,970       2,470  
New market tax credit carry-forward
    191       208  
Alternative minimum tax credit carry-forward
    692       685  
Net assets from acquisitions
    580       543  
Other than temporary impairment on securities
    374       374  
Amortization of non-compete agreements
    21       27  
Other
    734       827  
      45,651       36,442  
                 
Deferred tax liabilities:
               
Fixed assets
    410       445  
Net unrealized gain on securities available for sale
    2,070       2,242  
FHLB stock dividends
    1,276       1,276  
Originated mortgage servicing rights
    99       103  
Other
    583       659  
      4,438       4,725  
Net deferred tax assets before valuation allowance
    41,213       31,717  
Valuation allowance
    (41,213 )     (31,717 )
Net deferred tax asset
  $     $  

Our estimate of the realizability of the deferred tax asset depends on our estimate of projected future levels of taxable income as all carryback ability was fully absorbed by our estimated tax loss of approximately $40 million for 2011. In analyzing future taxable income levels, we considered all evidence currently available, both positive and negative. Based on our analysis, we established a valuation allowance for all deferred tax assets as of December 31, 2011. Our deferred tax assets and the related valuation allowance are analyzed and adjusted on a quarterly basis.

The Company does not have any beginning and ending unrecognized tax benefits.  The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months.  There were no interest and penalties recorded in the income statement or accrued for the nine months ended September 30, 2012 or the year ended December 31, 2011 related to unrecognized tax benefits.
 
The Company and its subsidiaries are subject to U.S. federal income tax and the Company is subject to income tax in the Commonwealth of Kentucky.  The Company is no longer subject to examination by taxing authorities for years before 2009.
 
 
30

 

Note 10 – Stock Plans and Stock Based Compensation
 
The Company has a stock option plan and a stock incentive plan. On February 23, 2006, the Company adopted the Porter Bancorp, Inc. 2006 Stock Incentive Plan. The 2006 Plan permits the issuance of up to 400,000 shares of the Company’s common stock upon the exercise of stock options or upon the grant of stock awards.  As of September 30, 2012, the Company had granted 158,022 unvested shares net of forfeitures and vesting under the stock incentive plan. Shares issued under the plan vest annually on the anniversary date of the grant over two to ten years. The Company has 137,957 shares remaining available for issue under the plan.  All shares issued under the above mentioned plans came from authorized and unissued shares.

On May 15, 2006, the Board of Directors approved the Porter Bancorp, Inc. 2006 Non-Employee Directors Stock Ownership Incentive Plan, which was approved by holders of the Company’s voting common stock on June 8, 2006.  On May 22, 2008, shareholders voted to amend the plan to change the form of incentive award from stock options to unvested shares. Under the terms of the plan, 100,000 shares are reserved for issuance to non-employee directors upon the exercise of stock options or upon the grant of unvested stock awards granted under the plan. Prior to the amendment, options were granted automatically under the plan at fair market value on the date of grant.  The options vest over a three-year period and have a five year term.  Unvested shares are granted automatically under the plan at fair market value on the date of grant and vest semi-annually on the anniversary date of the grant over three years.

On May 16, 2012, holders of the Company’s voting common stock voted to further amend the 2006 Non-Employee Directors Stock Ownership Incentive Plan to award restricted shares having a fair market value of $25,000 annually to each non-employee director, and to increase the number of shares issuable under the Directors’ Plan from 100,000 shares to 400,000 shares. Shares issued under the amended plan vest semi-annually on the anniversary date of the grant over three years.

To date, the Company has issued 96,610 unvested shares to non-employee directors. At September 30, 2012, 295,712 shares remain available for issuance under this plan.

The fair value of the 2012 unvested shares issued to certain employees was $169,000, or $1.74 per weighted-average share. The fair value of the 2012 unvested shares issued to non-employee directors was $155,000, or $1.65 per share. The Company recorded $338,000 and $342,000 of stock-based compensation during the first nine months of 2012 and 2011, respectively, to salaries and employee benefits.  There was no significant impact on compensation expense resulting from forfeited or expiring shares. We expect substantially all of the unvested shares outstanding at the end of the period will vest according to the vesting schedule. A deferred tax benefit of $0 and $116,000, respectively, was recognized related to this expense.

The following table summarizes unvested share activity as of and for the periods indicated:
 
   
Nine Months Ended
   
Twelve Months Ended
 
   
September 30, 2012
   
December 31, 2011
 
         
Weighted
         
Weighted
 
         
Average
         
Average
 
         
Grant
         
Grant
 
   
Shares
   
Price
   
Shares
   
Price
 
Outstanding, beginning
    100,226     $ 13.21       157,697     $ 13.43  
Granted
    191,140       1.69       2,800       5.36  
Vested
    (28,249 )     12.91       (35,836 )     13.00  
Forfeited
    (8,485 )     15.13       (24,435 )     14.04  
Outstanding, ending
    254,632     $ 4.53       100,226     $ 13.21  

As of September 30, 2012, all stock options issued to non-employee directors had expired and none were exercised during their grant term. When granted, stock options have an exercise price that is equal to or greater than the fair market value of the Company’s stock on the date the options were granted.  Options granted generally become fully exercisable at the end of three years of continued employment. Options have a life of five years.
 
 
31

 

The following table summarizes stock option activity:
 
   
Nine Months Ended
   
Twelve Months Ended
 
   
September 30, 2012
   
December 31, 2011
 
         
Weighted
         
Weighted
 
         
Average
         
Average
 
         
Exercise
         
Exercise
 
   
Shares
   
Price
   
Shares
   
Price
 
Outstanding, beginning
    29,530     $ 19.88       86,469     $ 20.72  
Forfeited
                (9,557     19.49  
Expired
    (29,530 )   19.88       (47,382 )     21.49  
Outstanding, ending
                29,530     $ 19.88  
 
No options were exercised during the first nine months of 2012.  The Company recorded no stock option compensation expense during the nine months ended September 30, 2012.  No options were modified during the period.  As of September 30, 2012, no stock options issued by the Company had been exercised, and all granted options had expired.

Unrecognized stock based compensation expense related to unvested shares for the remainder of 2012 and beyond are estimated as follows (in thousands):

October 2012 – December 2012
  $ 133  
2013
    457  
2014
    325  
2015
    131  
2016 & thereafter
    31  

Note 11 – Earnings (Loss) per Share

The factors used in the basic and diluted earnings per share computations follow:

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in thousands, except share and per share data)
 
   
Net loss
  $ (27,732 )   $ (12,162 )   $ (26,079 )   $ (51,352 )
Less:
                               
Preferred stock dividends
    437       437       1,312       1,312  
Accretion of Series A preferred stock discount
    44       45       134       133  
Loss attributable to unvested shares
    (501 )     (117 )     (345 )     (551 )
Loss attributable to Series C preferred
    (763 )     (346 )     (750 )     (1,444 )
Net loss attributable to common
                               
shareholders, basic and diluted
  $ (26,949 )   $ (12,181 )   $ (26,430 )   $ (50,802 )
   
Basic
                               
Weighted average common shares including
                               
unvested common shares outstanding
    12,303,217       12,167,168       12,219,035       12,172,926  
Less: Weighted average unvested
                               
common shares
    218,505       112,683       153,306       126,992  
Less: Weighted average Series C preferred
    332,894       332,894       332,894       332,894  
Weighted average common shares outstanding
    11,751,818       11,721,591       11,732,835       11,713,040  
   
Basic earnings (loss) per common share
  $ (2.29 )   $ (1.04 )   $ (2.25 )   $ (4.34 )
   
Diluted
                               
Add: Dilutive effects of assumed exercises
                               
of common and Preferred Series C
                               
stock warrants
    --       --       --       --  
Weighted average common shares and
                               
potential common shares
    11,751,818       11,721,591       11,732,835       11,713,040  
   
Diluted earnings (loss) per common share
  $ (2.29 )   $ (1.04 )   $ (2.25 )   $ (4.34 )

 
32

 
 
Stock options for 29,530 shares of common stock for 2011 were not considered in computing diluted earnings per common share because they were anti-dilutive.  The Company had no outstanding stock options at September 30, 2012.  Additionally, a warrant for the purchase of 330,561 shares of the Company’s common stock at an exercise price of $15.88 was outstanding at September 30, 2012 and 2011 but was not included in the diluted EPS computation as inclusion would have been anti-dilutive. Finally, warrants for the purchase of 1,380,437 shares of non-voting common stock at an exercise price of $11.50 per share were outstanding at September 30, 2012 and 2011, but were not included in the diluted EPS computation as inclusion would have been anti-dilutive.

Note 12 – Capital Requirements and Restrictions on Retained Earnings

Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
 
On June 24, 2011, PBI Bank entered into a Consent Order with the FDIC and the Kentucky Department of Financial Institutions.  The consent order required the Bank to complete a management study, to maintain Tier 1 capital as a percentage of total assets of at least 9% and a total risk based capital ratio of at least 12%, to develop a plan to reduce our risk position in each substandard asset in excess of $1 million, to complete board review of the adequacy of the allowance for loan losses prior to quarterly Call Report submissions, to adopt procedures which strengthen the loan review function and ensure timely and accurate grading of credit relationships, to charge-off all assets classified as loss, to develop a plan to reduce concentrations of construction and development loans to not more than 75% of total risk based capital and non-owner occupied commercial real estate loans to not more than 250% of total risk based capital, to limit asset growth to no more than 5% in any quarter or 10% annually, to not extend additional credit to any borrower classified substandard unless the board of directors adopts in advance a detailed statement giving reasons why the extension is in the best interest of the bank, and to not declare or pay any dividend without the prior consent of our regulators.  We are also restricted from accepting, renewing, or rolling-over brokered deposits without the prior receipt of a waiver on a case-by-case basis from our regulators.

On September 21, 2011, we entered into a Written Agreement with the Federal Reserve Bank of St. Louis.  Pursuant to the Agreement, we made formal commitments to use our financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without prior written approval, and to submit an acceptable plan to maintain sufficient capital.

In October 2012, PBI Bank entered into a new consent order with the FDIC and KDFI. The new consent order requires the Bank to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a sufficient capital investment into the Bank to fully meet the capital requirements. We expect to continue to work with our regulators toward capital ratio compliance as outlined in the written capital plan previously submitted by the Bank. The new consent order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 consent order, and includes the substantive provisions of the June 2011 consent order.
 
 
33

 

The following table shows the ratios of Tier 1 capital and total capital to risk-adjusted assets and the leverage ratios for Porter Bancorp, Inc. and PBI Bank at the dates indicated:

                     
September 30, 2012
   
December 31, 2011
 
   
Regulatory
Minimums
   
Well-Capitalized
Minimums
   
Minimum Capital
Ratios Under
Consent Order
   
Porter
Bancorp
   
PBI
Bank
   
Porter
Bancorp
   
PBI
Bank
 
                                           
Tier 1 Capital
    4.0 %     6.0 %     N/A       7.03 %     7.78 %     9.23 %     8.86 %
Total risk-based capital
    8.0       10.0       12.0 %     10.01       9.85       11.22       10.86  
Tier 1 leverage ratio
    4.0       5.0       9.0       5.00       5.53       6.53       6.23  

At September 30, 2012, PBI Bank’s Tier 1 leverage ratio was 5.53%, which is below the 9% minimum capital ratio required by the Consent Order, and its total risk-based capital ratio was 9.85%, which is below the 12% minimum capital ratio required by the Consent Order. Failure to meet minimum capital requirements could result in additional discretionary actions by regulators that, if undertaken, could have a materially adverse effect on our financial condition.

Kentucky banking laws limit the amount of dividends that may be paid to a holding company by its subsidiary banks without prior approval. These laws limit the amount of dividends that may be paid in any calendar year to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. PBI Bank has agreed with its primary regulators to obtain their written consent prior to declaring or paying any future dividends. As a practical matter, PBI Bank cannot pay dividends to Porter Bancorp for the foreseeable future.

Note 13 – Contingencies

In 2010, the Company sold common shares, convertible preferred shares and warrants to purchase common shares to accredited investors for $32 million in a private placement.  In the placement, an affiliate of Clinton Group, Inc. (“CGI”) purchased 456,524 common shares and warrants to purchase 228,262 common shares for $10.93 per share for $5,000,016.  The numbers of shares and the warrant exercise price have been adjusted to reflect the Company’s 5% stock dividend in November 2010.

On July 11, 2011, CGI sent a letter to the Company, which was also attached as an exhibit to a Schedule 13D CGI filed with the Securities and Exchange Commission on the same date.  In its letter CGI set forth concerns about the Company’s executive leadership team and its ability to properly manage the Bank's operations, compliance with GAAP, financial disclosures and relationships with regulators, referencing the consent order PBI Bank entered into with the Federal Deposit Insurance Corporation and the Commonwealth of Kentucky Department of Financial Institutions on June 24, 2011.  CGI listed a number of steps it believed the Company must take to maximize shareholder value and comply with the consent order. In addition, CGI stated its belief “that it is likely that a number of representations and warranties made when the CGI affiliate entered into an agreement to purchase shares were false,” and demanded that the Company take immediate steps to “redress such breaches and make CGI and the other purchasers whole.”

On July 20, 2011, the Company’s board of directors established a new Risk Policy and Oversight Committee comprised of independent directors, to lead the Board’s oversight of the assessment and management of the risks of Porter Bancorp and PBI Bank.  During the third quarter, the Oversight Committee undertook an investigation of the allegations raised in the CGI 13D to evaluate their merit and to ascertain the reasonableness of the Bank’s allowance for loan losses and OREO valuations at the time of Clinton’s investment.

The Oversight Committee reported its conclusions to the Company’s board of directors in October 2011.  While recognizing opportunities for procedural improvements existed in the Bank’s lending and non-performing asset administration, the  Oversight Committee concluded that this did not rise to a level that would result in the financial statements, or representations and warranties with respect to the financial statements, being misleading to investors in the 2010 private placement offering of the Company’s stock.  The Oversight Committee further concluded that investors were afforded ample opportunity and access to information for their due diligence, including documentation involving asset valuation estimates, on-site management discussions and additional inquiries during visits to the Company headquarters, and access to loan files of their choosing and the appraisals contained therein, and that the Company’s disclosures were adequate in all material respects.
 
 
34

 

In a letter dated November 28, 2011, which was filed as an exhibit to its 13D amendment, CGI was critical of the Oversight Committee’s investigation and restated its belief the Company’s balance sheet was overstated.  CGI called upon the independent directors to correct the balance sheet, replace the management team and raise capital.  On January 30, 2012, CGI delivered a demand to inspect the Company’s records pursuant to the Kentucky Business Corporation Act.  The Company has provided records to CGI in accordance with Kentucky law.

On June 18, 2010, three real estate development companies filed suit in Kentucky state court against PBI Bank and Managed Assets of Kentucky (“MAKY”). Signature Point Condominiums LLC, et al. v. PBI Bank, et al., Jefferson Circuit Court, Case No 10-CI-04295. The plaintiffs had borrowed funds from PBI Bank to finance a real estate development project in Jefferson County, Kentucky.  In March 2010, PBI agreed to release the plaintiffs and the guarantors on the loans related to the project, and in exchange the plaintiffs conveyed the real estate securing the loans to PBI Bank. PBI Bank also granted the plaintiffs a right of first refusal to repurchase a +/- 30 acre tract of land within the project.  In May 2010, PBI Bank submitted to plaintiffs the required notice of its intent to sell the land subject to the right of first refusal. After plaintiffs declined to exercise their right of first refusal, PBI Bank sold the land to MAKY in June 2010 for $3.8 million.

Plaintiffs filed suit shortly before the closing of the sale and recorded a lis pendens claiming an interest in the land, effectively preventing MAKY from taking clear title.  Plaintiffs have asserted claims of fraud, breach of fiduciary duty, breach of the duty of good faith and fair dealing, tortuous interference with prospective business advantage and conspiracy to commit fraud, negligence, and conspiracy against PBI Bank and MAKY.  Plaintiffs are seeking to rescind the agreement conveying the project to PBI Bank, but only with respect to the +/- 30 acre tract of land.  PBI has filed a counterclaim against the plaintiffs and a third party complaint against the guarantors, asserting claims of fraud. MAKY has asserted claims against the plaintiffs for slander of title and interference with business opportunities.  PBI’s position is that if the conveyance agreement is rescinded, then PBI’s notes, mortgages, and guarantees as well as the obligations of the plaintiffs and guarantors under the loans, which total more than $26 million, would all be reinstated.  PBI would then seek to enforce its rights under such instruments.  The matter is scheduled for trial in December 2012.  We have not accrued liability related to this matter as we believe we have meritorious claims and defenses.

In the normal course of operations, we are defendants in various legal proceedings.  We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain.  Currently, we do not believe that any of our pending legal proceedings or claims will have a material impact on our financial position or results of operations.

Item 2. Management’s Discussion and Analysis of Financial Condition
and Results of Operations

This item analyzes our financial condition, change in financial condition and results of operations. It should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes presented in Part I, Item 1 of this report.

Cautionary Note Regarding Forward-Looking Statements

This report contains statements about the future expectations, activities and events that constitute forward-looking statements. Forward-looking statements express our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we expressed or implied in any forward-looking statements. These risks and uncertainties can be difficult to predict and may be out of our control. Factors that could contribute to differences in our results include, but are not limited to the factors listed in Part II, Item 1A – Risk Factors in this report and the more detailed risks identified, and the cautionary statements included in our December 31, 2011 Annual Report on Form 10-K.
 
 
35

 

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. We caution you however, that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The forward-looking statements included in this report speak only as of the date of the report.  We have no duty, and do not intend to, update these statements unless applicable laws require us to do so.

Overview

Porter Bancorp, Inc. (NASDAQ: PBIB) is a Louisville, Kentucky-based bank holding company which operates 18 full-service banking offices in twelve counties through its wholly-owned subsidiary, PBI Bank. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt, and extend south along the Interstate 65 corridor to Tennessee. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky.  The Bank is a traditional community bank with a wide range of commercial and personal banking products, including wealth management and trust services, with an online banking division which delivers competitive deposit products and services under the separate brand of Ascencia.

The Company reported net loss of $27.7 million and $26.1 million, respectively, for the three and nine months ended September 30, 2012, compared with net loss of $12.2 million and $51.4 million, respectively, for the same periods of 2011.  After deductions for dividends on preferred stock, accretion on preferred stock, and loss allocated to participating securities, net loss to common shareholders was $26.9 million and $26.4 million, respectively, for the three and nine months ended September 30, 2012, compared with net loss to common shareholders of $12.2 million and $50.8 million, respectively, for the three and nine months ended September 30, 2011. Results for the first nine months of 2011 were negatively impacted by a non-recurring 100% goodwill impairment charge of $23.8 million and higher expense related to other real estate owned.

Basic and diluted loss per common share were $(2.29) and $(2.25) for the three and nine months ended September 30, 2012, respectively, compared with basic and diluted loss per common share of ($1.04) and ($4.34) for the three and nine months ended September 30, 2011, respectively.
 
Significant developments during the quarter and nine months ended September 30, 2012 consist of the following:

·  
Provision for loan losses expense was $25.5 million for the third quarter of 2012, compared with $4.0 million for the second quarter of 2012, and $8.0 million for the prior year third quarter. This increase was due to the continued decline in credit trends in our portfolio that resulted in net charge-offs of $23.1 million for the third quarter.  More specifically, the increase in the provision for loan losses in the third quarter 2012 is attributable to collateral value declines for impaired real estate secured loans as evidenced by new appraisals received during the quarter.  This resulted in a provision for loan loss totaling approximately $6.8 million related to these loans during the third quarter of 2012.

·  
The provision was also negatively impacted by a strategy change during the third quarter of 2012 related to classified loans which we expect to more quickly remediate by litigation or foreclosure. For loans subject to this expectation, we applied an additional fair value discount ranging from 10% to 33% to the underlying collateral in our impairment analysis estimates as resolution of this nature generally results in receiving lower values for real estate collateral in a more aggressive sales environment.  This resulted in a provision for loan loss of approximately $5.1 million related to these loans.  Additionally, the provision for loan losses was negatively impacted by the rising level of loan charge-offs in our historical loss experience factors, which we use to estimate the general component of our allowance for loan losses as well as additional downgrades within the loan portfolio.

·  
Net interest margin decreased 11 basis points to 3.35% in the first nine months of 2012 compared with 3.46% in the first nine months of 2011. The decrease in margin between periods was primarily due to a reduction in interest earning assets coupled with lower rates on those assets and elevated non-accrual loan levels. Average loans decreased 15.3% to $1.1 billion in the first nine months of 2012 compared with $1.3 billion in the first nine months of 2011.  Net loans decreased 23.0% to $898 million at September 30 2012, compared with $1.2 billion at September 30, 2011.

·  
We continue to execute on our strategy to reduce our commercial real estate and construction and development loans. Construction and development loans totaled $69.3 million, or 75% of total risk-based capital, at September 30, 2012 compared with $101.5 million, or 85% of total risk-based capital, at December 31, 2011.  Non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group totaled $339.9 million, or 368% of total risk-based capital, at September 30, 2012 compared with $414.6 million, or 349% of total risk-based capital, at December 31, 2011.
 
 
36

 
 
·  
Loan proceeds received from the repayment of our commercial real estate and construction and development loans were used primarily to redeem maturing certificates of deposit during the quarter. Deposits decreased 14.3% to $1.18 billion compared with $1.37 billion at September 30, 2011. Certificate of deposit balances declined $142.0 million during the first nine months of 2012 to $882.3 million at September 30, 2012, from $1.02 billion at December 31, 2011. Demand deposits increased 0.3% during the first nine months of 2012 compared with the fourth quarter of 2011, and increased 6.4% compared with the first nine months of 2011.

·  
Non-performing loans increased $8.4 million to $90.1 million at September 30, 2012, compared with $81.7 million at June 30 2012. The increase was primarily in the commercial real estate and residential real estate segments of our portfolio, partially offset by a decrease in the construction real estate segment.

·  
Loans past due 30-59 days increased from $6.7 million at June 30, 2012 to $9.6 million at September 30, 2012 and loans past due 60-89 days decreased from $4.4 million at June 30, 2012 to $3.6 million at September 30, 2012.

·  
Foreclosed properties were $48.8 million at September 30, 2012, compared with $54.4 million at June 30, 2012, and $44.9 million at September 30, 2011.  The Company acquired $3.4 million of OREO and sold $4.7 million of OREO during the third quarter of 2012. In addition, fair value write-downs of $4.3 million were recorded during the third quarter of 2012 to reflect declining values as evidenced by new appraisals and reduced marketing prices in connection with our sales strategies. Our ratio of non-performing assets to total assets increased to 10.8% at September 30, 2012, compared with 10.2% at June 30, 2012, and 6.64% at September 30, 2011.

·  
In October 2012, PBI Bank entered into a new Consent Order with the FDIC and KDFI. Under the new order, the Bank agreed to maintain the capital levels required by the June 2011 order and also agreed should the capital levels not be reached, and if directed in writing by the FDIC, the Bank would develop a plan to immediately raise sufficient capital, or to sell or merge itself into another FDIC insured institution. The new Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 order.

These items are discussed in further detail throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” Section.  For a discussion of our accounting policies, please see “Application of Critical Accounting Policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operation in our Annual Report on Form 10-K for the calendar year ended December 31, 2011.
 
Recent Developments and Future Plans
 
During the first nine months of 2012, we reported net loss to common shareholders of $26.4 million.  This loss was primarily attributable to $33.3 million of provision for loan losses expense due to continued decline in credit trends in our portfolio that resulted in net charge-offs of $31.8 million, OREO expense of $7.7 million resulting from fair value write-downs driven by new appraisals and reduced marketing prices, net loss on sales, and ongoing operating expense. We also had  lower net interest margin due to lower average loans outstanding, loans repricing at lower rates, and the level of non-performing loans in our portfolio. Net loss to common shareholders of $26.4 million, for the first nine months of 2012, compares with net loss to common shareholders of $50.8 million for the first nine months of 2011.
 
During the year ended December 31, 2011, we recorded a net loss to common shareholders of $105.2 million.  This loss was attributable to a $23.8 million goodwill impairment charge, the establishment of a $31.7 million valuation allowance on our deferred tax assets, OREO expense of $47.5 million related to valuation adjustments for our change in strategy related to certain properties, fair value write-downs related to new appraisals received for properties in the portfolio during 2011, net loss on the sale of OREO properties, and increase in carrying costs associated with carrying these higher levels of assets. We also recorded a provision for loan losses expense of $62.6 million due to the continued decline in credit trends within our portfolio.
 
In June 2011, the Bank agreed to a Consent Order with the FDIC and KDFI in which the Bank agreed, among other things, to improve asset quality, reduce loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%.  The Consent Order was included in our Current Report on 8-K filed on June 30, 2011. In October 2012, the Bank entered into a new Consent Order with the FDIC and KDFI again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a sufficient capital investment into the Bank to fully meet the capital requirements.
 
 
37

 
 
We expect to continue to work with our regulators toward capital ratio compliance as outlined in the written capital plan previously submitted by the Bank. The new Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. The new Consent Order was included in our Current Report on 8-K filed on September 19, 2012. As of September 30, 2012, the capital ratios required by the Consent Order were not met.
 
In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies to achieve the following objectives:
 
·  
Continuing to operate the Company and Bank in a safe and sound manner.  This strategy will require us to continue to reduce the size of our balance sheet, reduce our lending concentrations, consider selling loans, and reduce other noninterest expense through the disposition of OREO.
 
·  
Continuing with succession planning and adding resources to the management team.  In March 2012, the Board of Directors formed a search committee comprised of its five independent directors to identify and hire a President and CEO for PBI Bank.   John T. Taylor was named to these positions and appointed to the board of directors in July 2012.   Additionally, John R. Davis was appointed Chief Credit Officer of PBI Bank, with responsibility for establishing and executing the credit quality policies and overseeing credit administration for the organization.
 
·  
Evaluating our internal processes and procedures, distribution of labor, and work-flow to ensure we have adequately and appropriately deployed resources in an efficient manner in the current environment.  To this end, we believe the opportunity exists for the centralization of key processes which will lead to improved execution and cost savings.
 
·  
Raising capital by selling common stock through a public offering or private placement to existing and new investors.  At our 2012 annual meeting of shareholders, our shareholders approved an increase in our common shares authorized for issuance from 19 million shares to 86 million shares.  We continue to evaluate our opportunities to improve our capital structure and to increase common equity through the sale of additional common shares.  The Board of Directors has engaged an investment banking firm to assist in this evaluation and to explore options for the redemption of our Series A preferred stock issued to the US Treasury in 2008 under the Capital Purchase Program.
 
·  
Executing on our commitment to improve credit quality and reduce loan concentrations and balance sheet risk.
 
o  
We have reduced the size of our loan portfolio significantly from $1.3 billion at December 31, 2010 to $1.1 billion at December 31, 2011, and $952 million at September 30, 2012.   We have significantly improved our staffing in the commercial lending area which is now led by John R. Davis, who joined the team in August and now serves as Chief Credit Officer.
 
o  
Our Consent Order calls for us to reduce our construction and development loans to not more than 75% of total risk-based capital. We were in compliance at September 30, 2012 with construction and development loans representing 75% of total risk-based capital.  These loans totaled $69.3 million, or 75% of total risk-based capital, at September 30, 2012 and $101.5 million, or 85% of total risk-based capital, at December 31, 2011.
 
o  
Our Consent Order also requires us to reduce non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group, to not more than 250% of total risk-based capital.  While we have made significant improvements over the last year, we were not in compliance with this concentration limit at September 30, 2012.  These loans totaled $339.9 million, or 368% of total risk-based capital, at September 30, 2012 and $414.6 million, or 349% of total risk-based capital, at December 31, 2011.
 
 
38

 
 
o  
We are working to reduce these loans by curtailing new construction and development lending and new non-owner occupied commercial real estate lending.  We are also receiving principal reductions from amortizing credits and pay-downs from our customers who sell properties built for resale.  We have reduced the construction loan portfolio from $199.5 million at December 31, 2010 to $69.3 million at September 30, 2012.  Our non-owner occupied commercial real estate loans declined from $293.3 million at December 31, 2010 to $214.5 million at September 30, 2012.
 
·  
Executing on our commitment to sell other real estate owned and reinvest in quality income producing assets.
 
o  
The remediation process for loans secured by real estate has led the Bank to acquire significant levels of OREO in 2010 and 2011.  This trend has continued into 2012.  The Bank acquired $90.8 million and $41.9 million during 2010 and 2011, respectively.  For the first nine months of 2012, we acquired $31.5 million of OREO.
 
o  
We have incurred significant losses in disposing of this real estate.   We incurred losses totaling $13.9 million and $42.8 million in 2010 and 2011, respectively, from sales and fair value write-downs attributable to declining valuations as evidenced by new appraisals and from changes in our sales strategies.  During the nine month period ended September 30, 2012, we incurred OREO losses totaling $6.6 million, which consisted of $1.5 million in loss on sale and $5.1 million from declining values as evidenced by new appraisals and reduced marketing prices in connection with our sales strategies.
 
o  
To ensure that we maximize the value we receive upon the sale of OREO, we continue to evaluate sales opportunities and channels.  We are targeting multiple sales opportunities and channels through internal marketing and the use of brokers, auctions, technology sales platforms, and bulk sale strategies.  Proceeds from the sale or OREO totaled $17.6 million during the nine months ended September 30, 2012 and $25.0 and $26.0 million during fiscal 2010 and 2011, respectively.
 
o  
At December 31, 2011 the OREO portfolio consisted of 75% construction, development, and land assets.  At September 30, 2012 this concentration had declined to 54%.  This is consistent with our reduction of construction, development and other land loans,  which have declined to $69.3 million at September 30, 2012 compared to $101.5 million at December 31, 2011.  Over the past nine months, the composition of our OREO portfolio has shifted to be more heavily weighted towards commercial real estate properties with a cash flow opportunity and 1-4 family residential properties, which we have found to be more liquid than construction, development, and land assets.  Commercial real estate of this nature represents 31% of the portfolio at September 30, 2012 compared with 15% at December 31, 2011.  1-4 family residential properties represent 14% of the portfolio at September 30, 2012 compared with 7% at December 31, 2011.
 
·  
Evaluating other strategic alternatives, such as the sale of assets or branches.
 
Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order.  Based on individual circumstances, the agencies may issue mandatory directives, impose monetary penalties, initiate changes in management, or take more serious adverse actions.
 
Results of Operations
 
The following table summarizes components of income and expense and the change in those components for the three months ended September 30, 2012, compared with the same period of 2011:

   
For the Three Months
   
Change from
 
   
Ended September 30,
   
Prior Period
 
   
2012
   
2011
   
Amount
   
Percent
 
   
(dollars in thousands)
 
                         
Gross interest income
  $ 13,987     $ 18,103     $ (4,116 )     (22.7 )% 
Gross interest expense
    3,855       5,448       (1,593 )     (29.2
Net interest income
    10,132       12,655       (2,523 )     (19.9 )
Provision for loan losses
    25,500       8,000       17,500       218.8  
Non-interest income
    1,721       1,700       21       1.2  
Non-interest expense
    14,150       25,423       (11,273 )     (44.3 )
Net income (loss) before taxes
    (27,797 )     (19,068 )     (8,729 )     45.8  
Income tax expense (benefit)
    (65 )     (6,906 )     6,841       (99.1 )
Net income (loss)
    (27,732 )     (12,162 )     (15,570 )     128.0  
 
 
39

 
 
Net loss for the three months ended September 30, 2012 increased $15.6 million to $27.7 million compared with net loss of $12.2 million for the comparable period of 2011.  Provision for loan losses expense increased $17.5 million in the third quarter of 2012 compared with the same period in 2011 as the result of collateral value declines for certain larger collateral dependent commercial real estate credits as evidenced by new appraisals received during the quarter, higher net charge-offs, and a continued decline in credit trends in our portfolio. In addition, the third quarter 2012 provision for loan losses was negatively impacted by a strategy change during the third quarter of 2012 related to classified loans which we expect to more quickly remediate by litigation or foreclosure. For loans subject to this expectation, we applied an additional fair value discount to the underlying collateral in our impairment analysis estimates.  Net interest income decreased $2.5 million from the 2011 third quarter due to a 15 basis point decline in net interest margin due to lower earning asset levels, lower average rates, and higher non-performing assets. These results were partially off-set by a decrease in OREO expense of $11.8 million for the third quarter of 2012 compared with the same period of 2011 due to lower loss on sales of OREO, lower valuation write-downs, and lower property maintenance expense.

The following table summarizes components of income and expense and the change in those components for the nine months ended September 30, 2012 compared with the same period of 2011:

   
For the Nine Months
   
Change from
 
   
Ended September 30,
   
Prior Period
 
   
2012
   
2011
   
Amount
   
Percent
 
   
(dollars in thousands)
 
                         
Gross interest income
  $ 44,554     $ 56,917     $ (12,363 )     (21.7 )%
Gross interest expense
    12,173       17,053       (4,880 )     (28.6 )
Net interest income
    32,381       39,864       (7,483 )     (18.8 )
Provision for credit losses
    33,250       26,800       6,450       24.1  
Non-interest income
    8,184       6,352       1,832       28.8  
Non-interest expense
    33,459       89,577       (56,118 )     (62.6 )
Net income (loss) before taxes
    (26,144 )     (70,161 )     44,017       (62.7 )
Income tax expense (benefit)
    (65 )     (18,809 )     18,744       (99.7 )
Net income (loss)
    (26,079 )     (51,352 )     25,273       (49.2 )

Net loss of $26.1 million for the nine months ended September 30, 2012 represented a decrease of $25.3 million from net loss of $51.4 million for the comparable period of 2011.  A non-recurring 100% goodwill impairment charge of $23.8 million was recorded during the first nine months of 2011. OREO expense decreased $32.8 million from the first nine months of 2011 due to lower loss on sales of OREO, lower valuation write-downs, and lower property maintenance expense. Additionally, gain on sales of investment securities was $3.5 million for the first nine months of 2012 compared with $1.1 million for the first nine months of 2011. These improvements were partially offset by a decrease of $7.5 million in net interest income from the first nine months of 2011 due to an 11 basis point decline in net interest margin. In addition, provision for loan losses expense increased $6.5 million in the first nine months of 2012 compared with the same period in 2011 as the result of the continued decline in credit trends in our portfolio that resulted in higher net charge-offs compared to the previous period. More specifically, the 2012 provision for loan losses was negatively impacted by collateral value declines for certain larger collateral dependent commercial real estate credits as evidenced by new appraisals received during the period and a strategy change during the third quarter of 2012 related to classified loans which we expect to more quickly remediate by litigation or foreclosure. For loans subject to this expectation, we applied an additional fair value discount to the underlying collateral in our impairment analysis estimates.
 
 
40

 

Net Interest Income – Our net interest income was $10.1 million for the three months ended September 30, 2012, a decrease of $2.5 million, or 19.9%, compared with $12.7 million for the same period in 2011.  Net interest spread and margin were 3.09% and 3.23%, respectively, for the third quarter of 2012, compared with 3.22% and 3.38%, respectively, for the third quarter of 2011. Net interest income was $32.4 million for the nine months ended September 30, 2012, a decrease of $7.5 million, or 18.8%, compared with $39.9 million for the same period of 2011.  Net interest spread and margin were 3.19% and 3.35%, respectively, for the first nine months of 2012, compared with 3.30% and 3.46%, respectively, for the first nine months of 2011. Net average non-accrual loans were $90.2 million and $62.4 million in the first nine months of 2012 and 2011, respectively.

Average loans receivable declined approximately $219.0 million for the quarter ended September 30, 2012 compared with the third quarter of 2011.  This resulted in a decline in interest revenue of approximately $3.9 million for the quarter ended September 30, 2012 compared with the prior year period.  Average loans receivable declined approximately $193.4 million for the nine months ended September 30, 2012 compared with the first nine months of 2011.  This resulted in a decline in interest revenue of approximately $11.4 million for the nine months ended September 30, 2012 compared with the prior year period.  This decline in loan volume is attributable to soft loan demand in our markets as well as our efforts to reduce concentrations in our construction and development loan portfolio and our non-owner occupied commercial real estate loan portfolio.

Net interest margin decreased 15 basis points from our margin of 3.38% in the prior year third quarter.  The yield on earning assets declined 36 basis points from the third quarter of 2011, compared with a 23 basis point decline in rates paid on interest-bearing liabilities. Net interest margin for the first nine months of 2012 decreased 11 basis points from our margin of 3.46% in the first nine months of 2011 due primarily to lower average earning assets relative to average interest bearing liabilities. The yield on earning assets declined 33 basis points from the first nine months of 2011, compared with a 22 basis point decline in rates paid on interest-bearing liabilities.

Net interest margin for the third quarter of 2012 decreased 12 basis points from our margin of 3.35% in the second quarter of 2012, due primarily to lower average loan receivables and lower yield on loans, coupled with lower yield on investment securities. Average loan receivables declined $70.4 million from the second quarter of 2012, due to our efforts to reduce concentrations in our construction and development loan portfolio and in our non-owner occupied commercial real estate loan portfolio, and increased charge-offs. Yield on loans was adversely affected by an increase in interest foregone on non-accrual loans. Interest foregone on non-accrual loans totaled $1.1 million in the third quarter of 2012, compared with $1.3 million in the second quarter of 2012, and $790,000 in the first quarter of 2012. The decrease in yield on investment securities was the result of reinvestment of scheduled principal and interest payment proceeds and securities sales proceeds at lower rates. Yield on average earning assets for the third quarter of 2012 decreased 14 basis points from 4.59% in the second quarter of 2012, compared with a 3 basis points decrease in rates paid on interest-bearing liabilities from 1.39% in the second quarter of 2012.
 
 
41

 
 
Average Balance Sheets
 
The following table presents the average balance sheets for the three month periods ended September 30, 2012 and 2011, along with the related calculations of tax-equivalent net interest income, net interest margin and net interest spread for the related periods.

   
Three Months Ended September 30,
 
   
2012
   
2011
 
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
 
   
(dollars in thousands)
 
ASSETS
                                   
Interest-earning assets:
                                   
Loan receivables (1)(2)
  $ 1,008,053     $ 12,797       5.05 %   $ 1,227,024     $ 16,652       5.38 %
Securities
                                               
Taxable
    161,384       823       2.03       121,471       974       3.18  
Tax-exempt (3)
    28,075       220       4.80       31,471       298       5.78  
FHLB stock
    10,072       106       4.19       10,072       100       3.94  
Other equity securities
    1,359       14       4.10       1,400       13       3.68  
Federal funds sold and other
    52,921       27       0.20       114,946       66       0.23  
Total interest-earning assets
    1,261,864       13,987       4.45 %     1,506,384       18,103       4.81 %
Less: Allowance for loan losses
    (51,594 )                     (37,818 )                
Non-interest earning assets
    116,187                       157,024                  
Total assets
  $ 1,326,457                     $ 1,625,590                  
                                                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
Interest-bearing liabilities:
                                               
Certificates of deposit and other time deposits
  $ 899,118     $ 3,389       1.50 %   $ 1,100,280     $ 4,546       1.64 %
NOW and money market deposits
    146,913       141       0.38       163,198       361       0.88  
Savings accounts
    39,426       38       0.38       36,567       59       0.64  
Repurchase agreements
    2,260       2       0.35       11,029       119       4.28  
FHLB advances
    6,129       50       3.25       17,364       138       3.15  
Junior subordinated debentures
    32,199       235       2.90       33,099       225       2.70  
Total interest-bearing liabilities
    1,126,045       3,855       1.36 %     1,361,537       5,448       1.59 %
                                                 
Non-interest-bearing liabilities:
                                               
Non-interest-bearing deposits
    111,123                       105,498                  
Other liabilities
    8,260                       7,500                  
Total liabilities
    1,245,428                       1,474,535                  
Stockholders’ equity
    81,029                       151,055                  
Total liabilities and stockholders’ equity
  $ 1,326,457                     $ 1,625,590                  
                                                 
Net interest income
          $ 10,132                     $ 12,655          
                                                 
Net interest spread
                    3.09 %                     3.22 %
                                                 
Net interest margin
                    3.23 %                     3.38 %
 

(1)
Includes loan fees in both interest income and the calculation of yield on loans.
(2)
Calculations include non-accruing loans in average loan amounts outstanding.
(3)
Taxable equivalent yields are calculated assuming a 35% federal income tax rate.
 
 
42

 
 
Average Balance Sheets
 
The following table presents the average balance sheets for the nine month periods ended September 30, 2012 and 2011, along with the related calculations of tax-equivalent net interest income, net interest margin and net interest spread for the related periods.

   
Nine Months Ended September 30,
 
   
2012
   
2011
 
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
   
Average
Balance
   
Interest
Earned/Paid
   
Average
Yield/Cost
 
   
(dollars in thousands)
 
ASSETS
                                   
Interest-earning assets:
                                   
Loan receivables (1)(2)
  $ 1,068,356     $ 40,998       5.13 %   $ 1,261,790     $ 52,351       5.55 %
Securities
                                               
Taxable
    145,514       2,432       2.23       118,069       3,129       3.54  
Tax-exempt (3)
    26,059       666       5.25       28,754       826       5.91  
FHLB stock
    10,072       327       4.34       10,072       326       4.33  
Other equity securities
    1,359       43       4.23       1,400       39       3.72  
Federal funds sold and other
    55,230       88       0.21       138,980       246       0.24  
Total interest-earning assets
    1,306,590       44,554       4.59 %     1,559,065       56,917       4.92 %
Less: Allowance for loan losses
    (52,674 )                     (35,459 )                
Non-interest earning assets
    113,402                       166,780                  
Total assets
  $ 1,367,318                     $ 1,690,386                  
                                                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
Interest-bearing liabilities:
                                               
Certificates of deposit and other time deposits
  $ 935,061     $ 10,678       1.53 %   $ 1,141,997     $ 14,223       1.67 %
NOW and money market deposits
    149,718       496       0.44       169,159       1,193       0.94  
Savings accounts
    38,567       120       0.42       36,699       182       0.66  
Repurchase agreements
    2,019       6       0.40       11,180       355       4.25  
FHLB advances
    6,523       161       3.30       16,711       419       3.35  
Junior subordinated debentures
    32,421       712       2.93       33,323       681       2.73  
Total interest-bearing liabilities
    1,164,309       12,173       1.40 %     1,409,069       17,053       1.62 %
                                                 
Non-interest-bearing liabilities:
                                               
Non-interest-bearing deposits
    112,227                       105,266                  
Other liabilities
    7,565                       6,782                  
Total liabilities
    1,284,101                       1,521,117                  
Stockholders’ equity
    83,217                       169,269                  
Total liabilities and stockholders’ equity
  $ 1,367,318                     $ 1,690,386                  
                                                 
Net interest income
          $ 32,381                     $ 39,864          
                                                 
Net interest spread
                    3.19 %                     3.30 %
                                                 
Net interest margin
                    3.35 %                     3.46 %
 

(1)
Includes loan fees in both interest income and the calculation of yield on loans.
(2)
Calculations include non-accruing loans in average loan amounts outstanding.
(3)
Taxable equivalent yields are calculated assuming a 35% federal income tax rate.
 
 
43

 
 
Rate/Volume Analysis
 
The table below sets forth certain information regarding changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (changes in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.

   
Three Months Ended September 30,
2012 vs. 2011
   
Nine Months Ended September 30,
2012 vs. 2011
 
   
Increase (decrease)
due to change in
   
Net
Change
   
Increase (decrease)
due to change in
   
Net
Change
 
   
Rate
   
Volume
   
Rate
   
Volume
 
   
(in thousands)
 
Interest-earning assets:
                                   
Loan receivables
  $ (1,024 )   $ (2,831 )   $ (3,855 )   $ (3,732 )   $ (7,621 )   $ (11,353 )
Securities
    (490 )     261       (229 )     (1,450 )     593       (857 )
FHLB stock
    6             6       1             1  
Other equity securities
    1             1       5       (1 )     4  
Federal funds sold and other
    (6 )     (33 )     (39 )     (23 )     (135 )     (158 )
Total  decrease in interest income
    (1,513 )     (2,603 )     (4,116 )     (5,199 )     (7,164 )     (12,363 )
                                                 
Interest-bearing liabilities:
                                               
Certificates of deposit and other time deposits
    (375 )     (782 )     (1,157 )     (1,115 )     (2,430 )     (3,545 )
NOW and money market accounts
    (187 )     (33 )     (220 )     (573 )     (124 )     (697 )
Savings accounts
    (26 )     5       (21 )     (71 )     9       (62 )
Federal funds purchased and repurchased agreements
    (63 )     (54 )     (117 )     (183 )     (166 )     (349 )
FHLB advances
    4       (92 )     (88 )     (7 )     (251 )     (258 )
Junior subordinated debentures
    16       (6 )     10       50       (19 )     31  
Total decrease in interest expense
    (631 )     (962 )     (1,593 )     (1,899 )     (2,981 )     (4,880 )
Increase (decrease) in net interest income
  $ (882 )   $ (1,641 )   $ (2,523 )   $ (3,300 )   $ (4,183 )   $ (7,483 )
 
 
44

 
 
Non-Interest Income – The following table presents the major categories of non-interest income for the three and nine months ended September 30, 2012 and 2011:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
    (in thousands)  
Service charges on deposit accounts
  $ 563     $ 690     $ 1,673     $ 1,979  
Income from fiduciary activities
    261       237       803       738  
Bank card interchange fees
    180       168       553       500  
Other real estate owned rental income
    180       93       242       147  
Secondary market brokerage fees
    27       32       75       184  
Gains on sales of loans originated for sale
    138       123       260       664  
Gains on sales of investment securities, net
     —        —       3,530       1,108  
Other
    372       357       1,048       1,032  
Total non-interest income
  $ 1,721     $ 1,700     $ 8,184     $ 6,352  
 
Non-interest income for the third quarter ended September 30, 2012 increased $21,000, or 1.2%, compared with the third quarter of 2011.  The increase in non-interest income between the three month comparative periods was primarily due to increased income from fiduciary activities, bank card interchange fees, OREO rental income, and gains on sales of loans originated for sale. These increases were partially offset by lower service charges on deposit accounts, primarily due to decreased overdraft fees due to lower volumes than in past periods. For the nine months ended September 30, 2012, non-interest income increased by $1.8 million to $8.2 million compared with $6.4 million for the same period of 2011. The increase in non-interest income for the nine months ended September 30, 2012 was primarily due to increased gains on sales of investment securities, partially offset by lower service charges on deposit accounts due to lower transaction volume, and lower gains on sales of loans originated for sale due to fewer loans guaranteed by the USDA or SBA originated for sale.

Non-interest ExpenseThe following table presents the major categories of non-interest expense for the three and nine months ended September 30, 2012 and 2011:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
    (in thousands)  
Salary and employee benefits
  $ 4,264     $ 3,780     $ 12,558     $ 12,084  
Occupancy and equipment
    971       957       2,826       2,910  
Goodwill impairment charge
                      23,794  
Other real estate owned expense
    5,204       17,029       7,666       40,505  
FDIC insurance
    559       930       2,264       2,640  
Loan collection expense
    792       802       1,738       1,989  
Professional fees
    776       329       1,699       963  
State franchise tax
    496       582       1,680       1,746  
Communications
    175       176       523       509  
Postage and delivery
    108       117       339       368  
Office supplies
    96       93       274       273  
Advertising
    44       93       105       282  
Other
    665       535       1,787       1,514  
Total non-interest expense
  $ 14,150     $ 25,423     $ 33,459     $ 89,577  

Non-interest expense for the third quarter ended September 30, 2012 decreased $11.3 million, or 44.3%, compared with the third quarter of 2011. For the nine months ended September 30, 2012, non-interest expense decreased $56.2 million, or 62.6%, to $33.5 million compared with $89.6 million for the first nine months of 2011. The decreases in non-interest expense for the third quarter and nine months ended September 30, 2012, were primarily attributable to decreased other real estate owned expense due to lower loss on sales of OREO, lower valuation write-downs, and lower property maintenance expense; and lower FDIC insurance due to decreased deposit levels. Additionally, non-interest expense the first nine months of 2011 included a non-recurring 100% goodwill impairment charge of $23.8 million. These improvements were partially off-set by higher salaries and employee benefits expense due primarily to additions to staff in our credit administration and workout divisions, and higher professional fees due primarily to increased audit and accounting fees, and loan review fees.
 
 
45

 

Income Tax ExpenseIncome tax benefit was $6.9 million and $18.8 million, or 36.2% and 26.8% of pre-tax loss, for the three and nine months ended September 30, 2011, respectively. The income tax benefit of $65,000 recorded during the three and nine months ended September 30, 2012 is an adjustment to the prior year’s tax benefit. The income tax effect on net loss before taxes for the nine months ended September 30, 2012, increased our deferred tax assets and related valuation allowance by $9.5 million. See Footnote 9, “Income Taxes.”
 
Effective tax rates differ from the federal statutory rate of 35% applied to income before income taxes due to the following:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
    (dollars in thousands)  
Federal statutory rate times financial statement income
  $ (9,729 )   $ (6,673 )   $ (9,150 )   $ (24,556 )
Effect of:                                 
Net operating loss carry-forward
    9,760             9,376        
Tax-exempt income
    (78 )     (105 )     (237 )     (290 )
Goodwill impairment charge
                      6,169  
Non-taxable life insurance income
    (26 )     (29 )     (78 )     (78 )
Vesting of restricted stock
                      26  
Federal tax credits
          (11 )           (34 )
Other, net
    8       (88 )     24       (46 )
Total
  $ (65 )   $ (6,906 )   $ (65 )   $ (18,809 )

Analysis of Financial Condition

Total assets decreased $169.4 million, or 11.6%, to $1.29 billion at September 30, 2012, from $1.46 billion at December 31, 2011.  This decrease was primarily attributable to decreases of $185.7 million and $24.2 million in net loans and cash and cash equivalents, respectively. These decreases were partially offset by increases of $39.3 million in securities available for sale. The decrease in net loans was due to loan payoffs outpacing loan funding, net loan charge-offs of $31.8 million, and efforts to move impaired loans through the collection, foreclosure, and disposition process. The decrease in cash and cash equivalents was due to cash outflows related to maturing time deposits. The increase in securities available for sale was primarily related to the reinvestment of cash equivalents and loan cash flows into securities available for sale rather than new loans.

Loans ReceivableLoans receivable decreased $184.2 million, or 16.2%, during the nine months ended September 30, 2012 to $952 million. Our commercial, commercial real estate and real estate construction portfolios decreased by an aggregate of $127.6 million, or 18.6%, during the nine months and comprised 58.8% of the total loan portfolio at September 30, 2012. The decline in loans receivable was attributable to net charge-offs of $31.8 million, transfers to OREO of $31.5 million, and loan payoffs outpacing loan funding by approximately $64.3 million.
 
Loan Portfolio CompositionThe following table presents a summary of the loan portfolio at the dates indicated, net of deferred loan fees, by type. There are no foreign loans in our portfolio. Except for commercial real estate and residential real estate, there is no concentration of loans in any industry exceeding 10% of total loans.

   
As of September 30,
   
As of December 31,
 
   
2012
   
2011
 
   
Amount
   
Percent
   
Amount
   
Percent
 
         
(dollars in thousands)
       
                         
Commercial
  $ 56,050       5.89 %   $ 71,216       6.27 %
Commercial Real Estate
                               
Construction
    69,306       7.28       101,471       8.93  
Farmland
    84,426       8.87       90,958       8.01  
Other
    350,129       36.78       423,844       37.31  
Residential Real Estate
                               
Multi-family
    56,065       5.89       60,410       5.31  
1-4 Family
    287,613       30.22       337,350       29.70  
Consumer
    21,813       2.29       26,011       2.29  
Agriculture
    25,661       2.70       23,770       2.09  
Other
    748       0.08       993       0.09  
Total loans
  $ 951,811       100.00 %   $ 1,136,023       100.00 %
 
 
46

 

Non-Performing AssetsNon-performing assets consist of loans past due 90 days or more still on accrual, loans on which interest is no longer accrued, real estate acquired through foreclosure, and repossessed assets.

The following table sets forth information with respect to non-performing assets as of September 30, 2012 and December 31, 2011.
 
   
September 30,
2012
   
December 31,
2011
 
   
(dollars in thousands)
 
Loans past due 90 days or more still on accrual
  $ 1,486     $ 1,350  
Non-accrual loans
    88,632       92,020  
Total non-performing loans
    90,118       93,370  
Real estate acquired through foreclosure
    48,837       41,449  
Other repossessed assets
    5       5  
Total non-performing assets
  $ 138,960     $ 134,824  
Non-performing loans to total loans
    9.47 %     8.22 %
Non-performing assets to total assets
    10.81 %     9.26 %
Allowance for non-performing loans
  $ 11,100     $ 11,382  
Allowance for non-performing loans to non-performing loans
    12.32 %     12.19 %
 
Nonperforming loans at September 30, 2012, were $90.1 million, or 9.47% of total loans, compared with $59.8 million, or 4.96% of total loans, at September 30, 2011, and $93.4 million, or 8.22% of total loans at December 31, 2011.

Loans past due 30-59 days decreased from $17.3 million at December 31, 2011 to $9.6 million at September 30, 2012.  Loans past due 60-89 days decreased from $3.9 million at December 31, 2011 to $3.6 million at September 30, 2012. This represents an $8.1 million decrease from December 31, 2011 to September 30, 2012, in loans past due 30-89 days.  These decreases were primarily in the 1-4 family residential real estate, and commercial segments of the portfolio.  We considered this trend in delinquency levels during the evaluation of qualitative trends in the portfolio when establishing the general component of our allowance for loan losses.

Troubled Debt Restructuring – A troubled debt restructuring (TDR) is where the Company has agreed to a loan modification in the form of a concession for a borrower who is experiencing financial difficulty.  The majority of the Company’s TDRs involve a reduction in interest rate, a deferral of principal for a stated period of time, or an interest only period.  All TDRs are considered impaired, and the Company has allocated reserves for these loans to reflect the present value of the concessionary terms granted to the customer. If the loan is considered collateral dependent, it is reported net of allocated reserves, at the fair value of the collateral.

We do not have a formal loan modification program. Rather, we work with individual customers on a case-by-case basis to facilitate the orderly collection of our principal and interest before a loan becomes a non-performing loan. If a customer is unable to make contractual payments, we review the particular circumstances of that customer’s situation and negotiate a revised payment stream. In other words, we identify performing customers experiencing financial difficulties, and through negotiations, we lower their interest rate, most typically on a short-term basis for three to six months. Our goal when restructuring a credit is to afford the customer a reasonable period of time to remedy the issue causing cash flow constraints within their business so that they can return to performing status over time.
 
 
47

 
 
Our loan modifications have taken the form of reduction in interest rate and/or curtailment of scheduled principal payments for a short-term period, usually three to six months, but in some cases until maturity of the loan. In some circumstances we restructure real estate secured loans in a bifurcated fashion whereby we have a fully amortizing “A” loan at a market interest rate and an interest-only “B” loan at a reduced interest rate. Our restructured loans are all collateral secured loans. If a customer fails to perform under the modified terms, we place the loan(s) on non-accrual status and begin the process of working with the customer to liquidate the underlying collateral to satisfy the debt.

At September 30, 2012, we had 127 restructured loans totaling $117.5 million with borrowers who experienced deterioration in financial condition compared with 114 loans totaling $113.7 million at December 31, 2011. In general, these loans were granted interest rate reductions to provide cash flow relief to customers experiencing cash flow difficulties.  Of these loans, 6 loans totaling approximately $5.7 million were also granted principal payment deferrals until maturity. There were no concessions made to forgive principal relative to these loans, although we have recorded partial charge-offs for certain restructured loans. In general, these loans are secured by first liens on 1-4 residential or commercial real estate properties, or farmland.  Restructured loans also include $2.1 million of commercial loans.

In accordance with current guidance, we continue to report restructured loans as restructured until such time as the loan is paid in full, otherwise settled, sold, or charged-off. If the customer fails to perform, we place the loan on non-accrual status and seek to liquidate the underlying collateral for these loans. Our non-accrual policy for restructured loans is identical to our non-accrual policy for all loans. Our policy calls for a loan to be reported as non-accrual if it is maintained on a cash basis because of deterioration in the financial condition of the borrower, payment in full of principal and interest is not expected, or principal or interest has been in default for a period of 90 days or more unless the assets are both well secured and in the process of collection. Changes in value for impairment, including the amount attributed to the passage of time, are recorded entirely within the provision for loan losses.

We consider any loan that is restructured for a borrower experiencing financial difficulties due to a borrower’s potential inability to pay in accordance with contractual terms of the loan to be a troubled debt restructure.  Specifically, we consider a concession involving a modification of the loan terms, such as (i) a reduction of the stated interest rate, (ii) reduction or deferral of principal, or (iii) reduction or deferral of accrued interest at a stated interest rate lower than the current market rate for new debt with similar risk all to be troubled debt restructurings.  When a modification of terms is made for a competitive reason, we do not consider that to be a troubled debt restructuring.  A primary example of a competitive modification would be an interest rate reduction for a performing customer’s loan to a market rate as the result of a market decline in rates.

See Footnote 4, “Loans,” to the financial statements for additional disclosure related to troubled debt restructuring.

Foreclosed Properties – Foreclosed properties at September 30, 2012 were $48.8 million compared with $44.9 million at September 30, 2011 and $41.4 million at December 31, 2011.  See Footnote 5, “Other Real Estate Owned,” to the financial statements. During the first nine months of 2012, we acquired $31.5 million of OREO properties, and sold properties totaling approximately $19.1 million. We value foreclosed properties at fair value less estimated costs to sell when acquired and expect to liquidate these properties to recover our investment in the due course of business.

Other real estate owned (OREO) is recorded at fair market value less estimated cost to sell at time of acquisition.  Any write-down of the property at the time of acquisition is charged to the allowance for loan losses.  Subsequent reductions in fair value are recorded as non-interest expense.  To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers.  If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are recorded. 

For larger dollar commercial real estate properties, we obtain a new appraisal of the subject property in connection with the transfer to OREO.  In some of these circumstances, an appraisal is in process at quarter end and we must make our best estimate of the fair value of the underlying collateral based on our internal evaluation of the property, our review of the most recent appraisal, and discussions with the currently engaged appraiser.  We obtain updated appraisals on the anniversary date of ownership unless a sale is imminent.

Net loss on sales, write-downs, and operating expenses for OREO totaled $7.7 million for the nine months ended September 30, 2012, compared with $40.5 million for the same period of 2011. During the three months ended September 30, 2012, fair value write-downs of $4.3 million were recorded to reflect declining values as evidenced by new appraisals and reduced marketing prices in connection with our sales strategies. The 2011 results were significantly impacted by our determination in the 2011 second quarter that certain properties held in other real estate were not likely to be successfully disposed of in an acceptable time-frame using routine marketing efforts.  It became apparent that certain condominium projects were going to require extended holding periods to sell the properties at their most recent appraised values.  Accordingly, during June 2011, the Company sold, in a single transaction, 54 finished condominium property units from several condominium developments in our OREO portfolio, with a carrying value of approximately $11.0 million for $5.2 million, resulting in a pre-tax loss of $5.8 million.  In addition, management adjusted its valuations for similar condominium and residential development properties held in other real estate through provision of an allowance of $10.6 million on other real estate held, with the objective of marketing these properties more aggressively.
 
 
48

 

Allowance for Loan LossesThe allowance for loan losses is based on management’s continuing review and evaluation of individual loans, loss experience, current economic conditions, risk characteristics of various categories of loans and such other factors that, in management’s judgment, require current recognition in estimating loan losses.
 
Management has established loan grading procedures that result in specific allowance allocations for any estimated inherent risk of loss.  For loans not individually evaluated, a general allowance allocation is computed using factors developed over time based on actual loss experience.  The specific and general allocations plus consideration of qualitative factors represent management’s best estimate of probable losses contained in the loan portfolio at the evaluation date.  Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

Our loan loss reserve, as a percentage of total loans at September 30, 2012, increased to 5.68% from 3.27% at September 30, 2011, and from 4.63% at December 31, 2011.  Provision for loan losses increased $17.5 million to $25.5 million for the third quarter of 2012 compared with $8.0 million for the third quarter of 2011. Provision for loan losses increased $6.5 million to $33.3 million for the nine months ended September 30, 2012 compared with $26.8 million for the same nine months of 2011. The increase in the third quarter of 2012 is attributable to the continued decline in credit trends in our portfolio that resulted in higher net charge-offs compared to the prior period. More specifically, the 2012 provision for loan losses was negatively impacted by collateral value declines for certain larger commercial real estate loans as evidenced by new appraisals received during the third quarter.  In addition, the third quarter 2012 provision for loan losses was negatively impacted by a strategy change during the third quarter related to classified loans which we expect to more quickly remediate by litigation or foreclosure.  For loans subject to this expectation, we applied an additional fair value discount to the underlying collateral in our impairment analysis estimates as it has been our experience that resolution of this nature generally results in receiving lower values for real estate collateral in a more aggressive sales environment.

Net loan charge-offs for the third quarter of 2012 were $23.1 million, or 2.29% of average loans, compared with $7.2 million, or 0.59% of average loans, for the third quarter of 2011, and $6.4 million, or 0.59% of average loans, for the second quarter of 2012. Net charge-offs for the nine months ended September 30, 2012, were $31.8 million, or 2.98% of average loans, compared with $21.6 million, or 1.71% of average loans, for the first nine months of 2011. Our allowance for loan losses to non-performing loans was 59.94% at September 30, 2012, compared with 56.31% at December 31, 2011, and 66.05% at September 30, 2011.  The change in this metric between periods is attributable to the fluctuation in historical loss experience, qualitative factors, non-accrual loans, and provision expense.  We have assessed these loans for collectability and considered, among other things, the borrower’s ability to repay, the value of the underlying collateral, and other market conditions to ensure the allowance for loan losses is adequate to absorb probable incurred losses.

The majority of our nonperforming loans are secured by real estate collateral and the underlying collateral coverage for nonperforming loans supports the likelihood of collection of our principal. Our allowance for non-performing loans to non-performing loans was 12.3% at September 30, 2012 compared with 13.9% at September 30, 2011, and 12.2% at December 31, 2011.

 
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An analysis of changes in allowance for loan losses and selected ratios for the three and nine month periods ended September 30, 2012 and 2011, and for the year ended December 31, 2011 follows:
 
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
   
Year Ended
December 31,
 
   
2012
   
2011
   
2012
   
2011
   
2011
 
   
(dollars in thousands)
 
Balance at beginning of period
  $ 51,594     $ 38,717     $ 52,579     $ 34,285     $ 34,285  
Provision for loan losses
    25,500       8,000       33,250       26,800       62,600  
Recoveries
    412       142       697       237       340  
Charge-offs
    (23,487 )     (7,367 )     (32,507 )     (21,830 )     (44,646 )
Balance at end of period
  $ 54,019     $ 39,492     $ 54,019     $ 39,492     $ 52,579  
                                         
Allowance for loan losses to period-end loans
    5.68 %     3.27 %     5.68 %     3.27 %     4.63 %
Net charge-offs to average loans
    2.29 %     0.59 %     2.98 %     1.71 %     3.56 %
Allowance for loan losses to non-performing loans
    59.94 %     66.05 %     59.94 %     66.05 %     56.31 %

LiabilitiesTotal liabilities at September 30, 2012 were $1.23 billion compared with $1.37 billion at December 31, 2011, a decrease of $141.8 million, or 10.3%. This decrease was primarily attributable to a decrease in deposits of $146.2 million, or 11.0%, to $1.18 billion at September 30, 2012 from $1.32 billion at December 31, 2011. Certificate of deposit balances declined $142.0 million during the first nine months of 2012 to $882.3 million at September 30, 2012 from $1.02 billion at December 31, 2011. The decrease in deposits follows management’s strategy to match liability funding levels with lower loan balances.

Federal Home Loan Bank advances decreased by $1.2 million, or 16.2%, to $6.0 million at September 30, 2012, from $7.1 million at December 31, 2011.  These advances are used from time to time to fund asset growth and manage interest rate risk in accordance with our asset/liability management strategies.

Deposits are our primary source of funds. The following table sets forth the average daily balances and weighted average rates paid for our deposits for the periods indicated:

   
For the Nine Months
   
For the Year
 
   
Ended September 30,
   
Ended December 31,
 
   
2012
   
2011
 
   
Average
   
Average
   
Average
   
Average
 
   
Balance
   
Rate
   
Balance
   
Rate
 
    (dollars in thousands)  
Demand
  $ 112,227           $ 106,769    
 
 
Interest checking
    86,758       0.40 %     89,103       0.74 %
Money market
    62,960       0.50       81,925       0.96  
Savings
    38,567       0.42       36,511       0.62  
Certificates of deposit
    935,061       1.53       1,120,154       1.65  
Total deposits
  $ 1,235,573       1.22 %   $ 1,434,462       1.40 %
 
 
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The following table sets forth the average daily balances and weighted average rates paid for our certificates of deposit for the periods indicated:

   
For the Nine Months
   
For the Year
 
   
Ended September 30,
   
Ended December 31,
 
   
2012
   
2011
 
   
Average
   
Average
   
Average
   
Average
 
   
Balance
   
Rate
   
Balance
   
Rate
 
    (dollars in thousands)  
Less than $100,000
  $ 488,335       1.42 %   $ 569,667       1.59 %
$100,000 or more
    446,726       1.64 %     550,487       1.71 %
Total
  $ 935,061       1.53 %   $ 1,120,154       1.65 %

The following table shows at September 30, 2012 and December 31, 2011 the amount of our time deposits of $100,000 or more by time remaining until maturity:
 
   
As of
   
As of
 
   
September 30,
   
December 31,
 
Maturity Period
 
2012
   
2011
 
   
(in thousands)
 
Three months or less
  $ 94,750     $ 77,118  
Three months through six months
    92,379       65,359  
Six months through twelve months
    74,693       167,811  
Over twelve months
    160,228       183,056  
Total
  $ 422,050     $ 493,344  
 
Liquidity

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, taking into account all on- and off-balance sheet funding demands. Liquidity risk management also involves ensuring that we meet our cash flow needs at a reasonable cost. We maintain an investment and funds management policy, which identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. Our Asset Liability Committee regularly monitors and reviews our liquidity position.

Funds are available from a number of sources, including the sale of securities in the available-for-sale portion of the investment portfolio, principal pay-downs on loans and mortgage-backed securities, customer deposit inflows, brokered deposits and other wholesale funding. Historically, we have utilized brokered and wholesale deposits to supplement our funding strategy. At September 30, 2012, and December 31, 2011, these deposits totaled $104.1 million and $118.4 million, respectively. We are currently restricted from accepting, renewing, or rolling-over brokered deposits without the prior receipt of a waiver on a case-by-case basis from our regulators. It is our intent to redeem brokered deposits at maturity. The following table shows at September 30, 2012, the amount of our brokered certificates of deposit by time remaining to maturity (in thousands):

Three months or less
  $ 89,073  
Six months through twelve months
    15,000  
Total
  $ 104,073  
 
Traditionally, we have borrowed from the FHLB to supplement our funding requirements. The advances are collateralized by first mortgage residential loans. The borrowing capacity is based on the market value of the underlying pledged loans. At September 30, 2012, our additional borrowing capacity with the FHLB was $19.9 million. Any new advances are limited to a one year maturity or less.
 
We also have federal funds borrowing lines from major correspondent banks totaling $5.0 million on an unsecured basis. Management believes our sources of liquidity are adequate to meet expected cash needs for the foreseeable future, however, the availability of these lines could be affected by our financial position and our lenders could exercise their right to deny a funding request at their discretion. We are also subject to FDIC interest rate restrictions for deposits. As such, we are permitted to offer up to the “national rate” plus 75 basis points as published weekly by the FDIC.
 
 
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We use cash to pay dividends on common stock, if and when declared by the Board of Directors, and to service debt. The main sources of funding include dividends paid by PBI Bank, management fees received from affiliated banks and financing obtained in the capital markets. During 2011, Porter Bancorp contributed $13.1 million to its subsidiary, PBI Bank, which substantially decreased its liquid assets. The contribution was made to strengthen the Bank’s capital in an effort to help it comply with its capital ratio requirements under the consent order. Liquid assets decreased from $20.3 million at December 31, 2010, to $3.8 million at September 30, 2012. Since the Bank is unlikely to be in a position to pay dividends to the parent company for the foreseeable future, cash inflows for the parent are limited to management fees from affiliate banks, earnings on investment securities, sales of investment securities, and interest on deposits with the Bank. These cash inflows along with the liquid assets held at September 30, 2012, totaling $3.8 million, are needed for the ongoing cash operating expenses of the parent company which have been reduced and are expected to be $1.5 million for 2012. We have elected to defer payments on our Series A preferred stock and on our trust preferred securities. The reduction in expected expenses for 2012 from actual cash expenses for 2011 is primarily the result of deferring payments on our Series A preferred stock issued to the U.S. Treasury and on our trust preferred securities. Parent company liquidity could be improved if a capital raise was completed.

Capital

In the fourth quarter of 2011, we began deferring the payment of regular quarterly cash dividends on our Series A Preferred Stock issued to the U.S. Treasury.  At September 30, 2012, cumulative accrued and unpaid dividends on this stock totaled $2.0 million. If we defer dividend payments for six quarters, the holder of our Series A Preferred Stock (currently the U.S. Treasury) would then have the right to appoint representatives to our Board of Directors. We will continue to accrue any deferred dividends, which will be deducted from income to common shareholders for financial statement purposes.

In addition, effective with the fourth quarter of 2011, we began deferring interest payments on our junior subordinated notes which resulted in a deferral of distributions on our trust preferred securities. We have the option to defer interest payments from time-to-time for a period not to exceed 20 consecutive quarters. Thereafter, we must pay all deferred interest and resume quarterly interest payments or we will be in default. Future cash dividends on our common stock are subject to the prior payment of all deferred distributions on our trust preferred securities. At September 30, 2012, cumulative accrued and unpaid interest on our junior subordinated notes totaled $707,000.

Stockholders’ equity decreased $27.5 million to $55.0 million at September 30, 2012, compared with $82.5 million at December 31, 2011. The decrease was due the current year net loss, further reduced by dividends declared on cumulative preferred stock and net reduction in unrealized gain on available for sale securities.

Each of the federal bank regulatory agencies has established risk-based capital requirements for banking organizations. In addition, PBI Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets (“total risk-based capital ratio”) of at least 12.0%, and a ratio of Tier 1 capital to total assets (“leverage ratio”) of 9.0%. The Bank is currently not in compliance with this requirement.

The following table shows the ratios of Tier 1 capital and total capital to risk-adjusted assets and the leverage ratios for Porter Bancorp, Inc. and PBI Bank at the dates indicated:

                     
September 30, 2012
   
December 31, 2011
 
   
Regulatory
Minimums
   
Well-Capitalized
Minimums
   
Minimum Capital
Ratios Under
Consent Order
   
Porter
Bancorp
   
PBI
Bank
   
Porter
Bancorp
   
PBI
Bank
 
                                           
Tier 1 Capital
    4.0 %     6.0 %     N/A       7.03 %     7.78 %     9.23 %     8.86 %
Total risk-based capital
    8.0       10.0       12.0 %     10.01       9.85       11.22       10.86  
Tier 1 leverage ratio
    4.0       5.0       9.0       5.00       5.53       6.53       6.23  
 
 
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At September 30, 2012, PBI Bank’s Tier 1 leverage ratio was 5.53%, which is below the 9% minimum capital ratio required by the Consent Order, and its total risk-based capital ratio was 9.85%, which is below the 12% minimum capital ratio required by the Consent Order. Failure to meet minimum capital requirements could result in additional discretionary actions by regulators that, if undertaken, could have a materially adverse effect on our financial condition.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company’s interest sensitivity profile was asset sensitive at September 30, 2012, and December 31, 2011. Given a 100 basis point increase in interest rates sustained for one year, base net interest income would increase by an estimated 4.3% at September 30, 2012, compared with an increase of 5.8% at December 31, 2011, and is within the risk tolerance parameters of our risk management policy. Given a 200 basis point increase in interest rates sustained for one year, base net interest income would increase by an estimated 8.3% at September 30, 2012, compared with an increase of 10.9% at December 31, 2011, and is within the risk tolerance parameters of our risk management policy.
The following table indicates the estimated impact on net interest income under various interest rate scenarios for the twelve months following September 30, 2012, as calculated using the static shock model approach:
 
   
Change in Future
Net Interest Income
 
    Dollar Change      Percentage Change  
    (dollars in thousands)  
+ 200 basis points
  $ 3,085       8.31 %
+ 100 basis points
    1,592       4.29  

We did not run a model simulation for declining interest rates as of September 30, 2012, because the Federal Reserve effectively lowered the federal funds target rate between 0.00% to 0.25% in December 2008.  Therefore, no significant further short-term rate reductions can occur.

Item 4. Controls and Procedures

Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of September 30, 2012, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures.

As a result of regulatory examination and audit processes applied to our loan grading activities shortly before and after year end 2011, we determined that our internal process for assigning loan grades did not always establish an accurate grade for credit risk.  Our internal control processes surrounding loan grades, which consist of a combination of internal and external loan review activities, identified and corrected grades for the majority of loans that were not initially graded correctly.  However, our loan review had not sufficiently covered all loans subject to potential grading error throughout the 2011 fiscal year.  In preparing our annual report on Form 10-K, we identified the extent to which our loan review controls did not operate and expanded the scope to cover the remainder of the portfolio and adjusted our allowance for loan losses to take the additional findings into consideration.  Accordingly, we determined the controls regarding the determination of loan grades were not operating effectively as of December 31, 2011.  Our management, overseen by the Audit Committee, worked throughout the first nine months of 2012 and continues to work to implement steps to improve the control weaknesses for loan grading discovered in the closing process for the year and quarter ended December 31, 2011.

These enhanced procedures include:

·  
Completion of additional independent internal and external loan reviews of the portfolio to ensure accurate grading from March 2012 through September 2012.
·  
Review of the portfolio by assigned loan officer for proper grading.
·  
Analytical review of the portfolio by management based upon payment performance.
·  
Retention of John R. Davis to serve as Chief Credit Officer overseeing credit administration and credit quality policy and procedures.
·  
Implementation of a centralized loan administration and analysis team within the credit department to ensure more timely and regular review of grading, performance metrics, financial information, and collateral.
 
 
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During the first nine months of 2012, we took steps to resolve the material weakness by changing our procedures for loan grading, as discussed above. Notwithstanding the steps taken during this period, the identified material weakness will not be considered remediated until the new procedures have been in operation for a sufficient period of time to be tested and determined by management to be operating effectively. Based on our evaluation and the reasons described above, management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report. There were no other changes in our internal control over financial reporting that occurred during the nine months ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 
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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

In the normal course of operations, we are defendants in various legal proceedings.  Except as described in Footnote 13, “Contingencies” in the Notes to our consolidated financial statement, in the opinion of management, there is no known legal proceeding pending which an adverse decision would be expected to result in a material adverse change in our business or consolidated financial position. See Footnote 13, “Contingencies” in the Notes to our consolidated financial statements for additional detail regarding ongoing legal proceedings.

Item 1A. Risk Factors

Information regarding risk factors appears in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 under Item 1A – Risk Factors.  There have been no material changes from the risk factors previously discussed in our Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3. Default Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

Not applicable.

Item 6. Exhibits

(a)           Exhibits
The following exhibits are filed or furnished as part of this report:

Exhibit Number
Description of Exhibit
 
10.1
Form of Porter Bancorp, Inc. Restricted Stock Award Agreement, 2006 Stock Incentive Plan.
 
10.2
Employment Agreement of John R. Davis, incorporated by reference to 8-K filed
 
September 19, 2012.
 
31.1
Certification of Principal Executive Officer, pursuant to Rule 13a - 14(a).
 
31.2
Certification of Principal Financial Officer, pursuant to Rule 13a - 14(a).
 
32.1
Certification of Principal Executive Officer, pursuant to 18 U.S.C Section 1350,
 
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
32.2
Certification of Principal Financial Officer, pursuant to 18 U.S.C Section 1350,
 
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   
101
The following financial statements from the Company’s Quarterly Report on Form 10Q for the quarter ended September 30, 2012, formatted in XBRL: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Loss, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows, (vi) Notes to Consolidated Financial Statements.
 
 
55

 
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act if 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 

 
PORTER BANCORP, INC.
 
(Registrant)
 
November 13, 2012
By:
/s/ Maria L. Bouvette
   
Maria L. Bouvette
   
Chairman & Chief Executive Officer
 
November 13, 2012
By:
/s/ Phillip W. Barnhouse
    Phillip W. Barnhouse 
   
Chief Financial Officer and Chief
   
Accounting Officer
 
 
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